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VRDWhat?

Variable Rate Demand Obligations – that’s right, Variable Rate Demand Obligations, or “VRDOs”.  To most investors, the name is entirely “Greek” as is the nature of how the instruments work.  But VRDOs represent a holdings play generating a hugely important yield component in municipal money market funds as well as for many institutional cash managers.  And, since November of 2007, they’re also available via an ETF structure.

VRDOs are nothing new.  In fact, VRDOs have been around since the early 1980s and presently comprise roughly $500 billion of municipal bond issues (according to PowerShares, April 2009).

So why haven’t most individual investors heard about these long ago?  VRDOs aren’t common kitchen-table talk topics in most homes or, for that matter, in most investment advisory shops.

First, at $100,000 per unit, VRDOs are not “pocket change” to most investors.  Secondly, the fact that liquidity is available only weekly and only via the exercise of a put option makes VRDOs very much a “hands-on” cash management tool requiring more touch and attention than most investors and advisors are accustomed to.  Further, advisors themselves generally just don’t have a good understanding of what VRDO instruments are, how they work or related risks.

So how can VRDOs be of interest to investors using ETFs?  VRDO ETFs can serve as an attractive source of tax-exempt income in a form that has demonstrated a highly stable NAV through some pretty challenging times since the launch of PowerShares’ PVI in November 2007.  And the industry’s second VRDO ETF, State Street’s VRD, came to market just last month.

Let’s take apart a VRDO to get a sense as to how these instruments work and the characteristics they impart to an ETF.

VRDOs are fixed, long-maturity bonds – typically thirty to forty years – and are issued by municipalities.  But VRDOs carry a put-option feature that allows the holder to put the bonds back to the issuer, or a surrogate liquidity provider, at par plus accrued interest.  Most VRDOs have a 7-day put feature, meaning that the instrument can be put back to the issuer or liquidity provider on a weekly basis (with typically up to five business days for settlement following exercise).

The definitive put feature enables classification of VRDOs as short-term debt or cash instruments by their holders.  This important aspect makes VRDOs eligible for holding in most tax-exempt money market funds where, consequently, they represent an important yield component.

Yields for 7-day VRDOs are reset weekly according to indexes maintained by the Bond Marketing Association.

For municipalities, the attraction of VRDOs is that they enable long-term debt to be financed at short-term rates.  The trade-off for municipalities is the taking on of floating-rate risk and the specter of higher interest rates.

As a practical matter, most municipalities are not operationally well-disposed to manage the ebb and flow of VRDO holders’ exercise of puts and the ensuing need to resell the previously put-tendered VRDOs.  Accordingly, most VRDOs are wrapped with a liquidity assurance supported by a bank-issued letter-of-credit to ensure return of principal plus accrued interest for holders following the exercise of VRDO puts.  Many long-term municipal bonds – including many VRDOs – are also insured against default.

As with all debt instruments, there are liquidity and credit risks to holders of VRDOs which, in the end, could compromise a holder’s ability to recoup interest and principal from the issuer or the market.

VRDO provisions typically enable the immediate retraction of the liquidity put feature by the provider of the bank-issued letter of credit when the rating of the issuer (or, if the issuer is insured, the higher rating of the municipality or its insurer) drops below investment grade (BBB-/Baa3).

Declines in issuer (or insurer, if applicable) to levels below (typically) AA/AA2 or AA-/Aa3 can also trigger a retraction of the put feature but typically only after a 30-day notice period during which time holders may put the bonds to the liquidity provider.

Consequently, the greatest liquidity and credit risk to a VRDO holder would tend to be associated with a rapid plunge in rating of the issuer (or insurer, if applicable) to below investment grade – causing the bond to behave as a non-investment grade, long-maturity debt instrument with yields still reset weekly at short-term rates.

Since the spring of 2008 the Federal Reserve and Treasury have taken steps to enable liquidity providers to pledge many VRDO securities as collateral – greatly reducing liquidity risk for banks providing liquidity wrap features to VRDOs.

As of October 2, PowerShares PVI held $1.02 billion in assets spread across 127 holdings.  PowerShares reports that “PVI’s NAV has stayed within a range of $24.97 to $25.10 from its inception through May 2009” while maintaining “an average price spread of $.01, putting it on a par with some of the most liquid securities in the market today.”  The 30-day SEC yield on October 2 was 0.80% (roughly 1.23% taxable equivalent yield for a 35% federal income tax bracket).

PVI’s expense ratio stands at 0.25% while State Street’s VRD clocks in at 0.20%.

Glass half full? … What you see is what you get but what about what you don’t see?

Municipal VRDOs represent a great innovation that has, so far, withstood severe market stresses of the current crisis as well as recessions and market shocks of the past nearly thirty years.  However, the challenges faced by municipal bond markets today are arguably more acute than at anytime during all of our lifetimes.

Full disclosure of ETF holdings on a daily basis provides a clear picture of the VRDO bonds held in PVI or VRD.  This is an important advantage relative to the severely lagged reporting on holdings in money market mutual funds where publishing of holdings is quarterly and up to sixty days in arrears.  What you see, holdings-wise in the ETF, is what you get.  What you see in the money market fund holdings disclosures is what you had at a single point in time, sometime between three months ago and five months ago.

Quite unfortunately, what you won’t currently find in money market fund disclosures or in VRDO ETF literature is a description of holdings by provider of liquidity support or by bond insurer.  Prospectuses do, in their statements of risk, highlight the fact that insurers are relatively large and concentrated such that financial trouble with one or more of these large institutions could have an adverse impact on holdings in the fund.  Disclosures of a similar kind are noted in regards to VRDO liquidity providers.  And yet, in fund descriptions, single bond and VRDO holdings are listed but distribution and concentrations across liquidity providers and credit insurers are not, even though these are acknowledged to exist and to constitute a material source of risk.

In the end, position disclosure by ETFs is significantly better than what is generally provided by municipal money market funds.  And, for that reason, PVI or VRD can make a very solid case, for the sake of clarity and (at least partial) peace of mind, relative to municipal money market mutual funds.  As with other holdings, including money market funds, moderation is the key.

3 Risks Of Bond ETFs

Exchange traded funds are known for their ability to provide diversification, low cost alternatives, asset allocation and exposure to hard to reach markets and sectors.  From a portfolio management and asset class perspective, bond ETFs do such a thing, however, it is equally important to understanding the inherent risks involved with these versatile investment tools.

The first risk involved with bond ETFs is the risk of default.  Bond ETFs hold actual bonds which are promissory notes.  So in essence, these promissory notes are only as good as the government, agency or corporation that issues it. 

The second risk is interest-rate risk.  If interest rates rise higher than the bond coupon rate, then an investor is losing out and will have to sell their bond at a discount.  One could hold the bond ETF to maturity, but that involves great opportunity cost.  The longer the maturity of a bond, the greater the interest-rate risk.  For this reason, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) carries a substantially higher interest rate risk, while the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) carries very little.

The third, and probably biggest, risk involved is inflation risk.  This influences bond ETFs when the coupon rate on bonds held is 3%, for example, and inflation is 5%.  There are bonds that are immune to inflation, such as the iShares Barcalys TIPS Bond Fund (TIP), which is an inflation-protected bond ETF, but most fixed income ETFs carry interest rate risk and deflation risks.  If prices start to drop, then an inflation adjustment will be worthless.   

Bond ETFs are essential to a well balanced portfolio, but as with everything else, it is important to know the advantages and disadvantages that are involved.

Getting Granular in Fixed Income

Imperatives wrought by emerging deflation/inflation risks

During the past year, much has been said and written about inflation risk. And more recently, there has been increased chatter regarding deflation risk as well – with some analysts discussing the two as a sequential possibility, with deflation striking first.

Nobody can say with certainty how the deflation/inflation dynamic will play or precisely when significant shifts will occur.

We can say with confidence, however, that the macro-economic environments of 2012 and 2015 will be considerably different from what we see today or the macro environment that prevailed prior to mid-2007.

The secular declines in interest and inflation rates that emerged following the 1987 crash and in the wake of the late 1980s S&L crisis have been definitively constructive to both equity and bond performance over the past twenty years. A progressively weaker dollar in the 2000s and a consumer credit bubble that got rolling in the 90s, but exploded in the 2000s, were also constructive to equities and bonds of nearly all stripes.

Looking ahead, though, expectations are generally for historically wide swings in deflation/inflation rates, interest rates, currency exchange rates and, rather generically, in risk appetites. From an investment and risk management perspective, deflationary and inflationary swings are likely to have pronounced and highly varied impacts across segments of fixed income markets. Accordingly, greater discernment between subsets of the broader fixed income asset class is likely to be of far greater importance in the coming decade than it has at any time in recent decades. If you want to find out more about exchange rates/ currencies, click here to find out more info.

For example, a severe deflationary cycle would – as Pimco’s Bill Gross recently suggested – likely be supportive of Treasuries across the maturity spectrum, but in the intermediate and long segments in particular. Corporates, though, would suffer from the flight to safety of Treasuries to an extent dependent on the scale and intensity of a deflationary turn.

A severe inflationary cycle, however, would be constructive to TIPS and short-term bonds while quite damaging to longer maturity Treasuries and corporates.

Also posing challenges to the management of bond portfolio risk is the rapidly evolving dollar relationship relative to both developed and emerging market currencies. A rapidly expanding Treasury bond supply across economies, especially those running large and protracted current account deficits such as the U.S., is an important shaper of interest and exchange rates.

And, too, the printing of money is in vogue – in the U.S. it is currently taking on the form of repurchase of Treasuries by the Federal Reserve Bank even as the issuance of Treasuries is running roughly triple the pace of a year ago. The FRB/Treasury has also become the preferred parking garage for significant volumes of mortgage and consumer debt-backed securities posted as collateral by major banks for funding at cheap short-term borrowing rates.

The need to consider staying tactically nimble in fixed income and the benefits of knowing what you have in ETFs, on a daily basis, make segmentation of the broader fixed income asset class in ETFs an important exercise for all risk managers.

Here’s a look at what most investors would need to cover every major segment of the broader fixed income asset class. There are no less than six noteworthy U.S. segments and three international segments.

US Government issues – Treasuries: SHY (1-3 Yr), IEI (3-7 Yr), IEF (7-10 Yr), TLH (10-20), TLT (20+ Yr), PLW (1-30 Yr Laddered).

US Agency issues – Mortgage backed: MBB, MBG

US Corporates: Investment-grade, LQD: High-yield, HYG, JNK

US Municipals: TFI; SHM (short-term)

US Convertibles: CWB

US TIPS: TIP; STPZ (short-term)

International developed market treasuries: BWX (local currency-denominated); BWZ (short-term; local currency-denominated)

International emerging market treasuries: PCY (dollar-denominated), EMB (dollar-denominated)

International TIPS: WIP (local currency-denominated)

Understanding performance and risk attributes of individual segments of the fixed income asset class will be far more important over the next three to five years than at any time during the past twenty years. Where a diversified aggregate bond holding might have sufficed during the secular decline in interest and inflation rates, massive performance divergences might render fixed income segmentation critical in the potentially dramatically different interest rate, inflation rate and dollar value environments going forward.

Asia and its Vast Array of ETFs

As the dollar continues to show signs of weakness and the U.S. is digging itself out of a recession, many have turned to Asia making the emerging continent a headline amongst many.

Asia has drawn attention due to its large growth rates and its ability to emerge out of the global recession with a V-shaped recovery.  Take Hong Kong for example, whose economy grew at a seasonally adjusted 3.3% in the second quarter of the year and China who is expected to grow at a rate of 8% for the year.  These nations have been able to pull themselves up by their boot straps, mainly due to fiscal stimulus plans which accounted for nearly 4% of GDP and were higher than any other region of the world. 

Government stimulus packages have been successful in Asian nations due to low consumer debt, and a high propensity to save.  This way of life has led these nations to further develop and enable incomes to rise, which will likely cause the domestic demand for goods and services to increase as well.  In fact, demand from domestic consumption is expected to add nearly 7% to the growth rate of the smaller emerging nations of Asia.  

To add to the region’s attractiveness, most nations have kept unemployment rates relatively tame, many big technology companies in the region are increasing capital expenditure projections, and the International Monetary Fund has openly stated that it expects the region as a whole to continue to grow. 

Lastly, Asian nations are diligently working together to construct an agreement that will free up trade.  Over time, this will help the region by lowering economic barriers, further enabling nations to develop more efficient economies of scale.  Additionally, the agreement could potentially increase the inflow of foreign direct investment which could further lead to technological advancements and even more economic growth.

For most, when they speak of Asia they think of Japan, China and India, but it is just as easy to gain access to the region’s other markets, which will probably show even more prosperity, through the following ETFs:

• iShares MSCI Hong Kong Index (EWH), which carries an expense ratio of 0.52% and gives exposure to Hong Kong which has benefited from China’s growth and stimulus package.
• iShares MSCI South Korea Index (EWY), which has an expense ratio of 0.63% and gives great exposure to South Korea which is heavily reliant on China and is highly correlated with developed nations.
• iShares MSCI Singapore Index (EWS), which has an expense ratio of 0.52% and relies on manufacturing, which is expected to see signs of recovery.
• iShares MSCI Taiwan (EWT), which has an expense ratio of 0.63% and is being bolstered by exports to China, low interest rates and stable consumer prices.

The Ins and Outs of Hard Assets

Hard assets have traditionally been a great way to diversify a portfolio and protect against inflation and overall market turmoil.  When considering hard assets, many think of precious metals such as gold and silver, however, there is a wide array of choices that can be easily accessed in a cost-efficient manner through exchange traded funds.  As an alternative to the more pure exposure provided through ownership of physical commodities or through futures contracts, ETFs also provide alternative, indirect access via the stocks of companies participating in the production, processing and distribution of commodities.  Exposure can also be accessed via exchange traded notes (ETNs) – debt instruments that commit to deliver the total return of a commodity index.

Examples of equity-based ETFs covering companies that participate in the production and handling of commodities are SPDR S&P Metals & Mining (XME) or the Market Vectors RVE Hard Assets Producers (HAP).  XME provides exposure to large companies like US Steel and Alcoa and has an expense ratio of 0.35%.  HAP, on the other hand, is a bit more diverse providing exposure to water and renewable energy in addition to metals and mining.  It carries an expense ratio of 0.65%.

The ETN alternative can be tapped through the following Barclay’s iPath family of commodity ETNs:

• iPath Dow Jones UBS Industrial Metals Subindex Total Return (JJM)
• iPath Dow Jones AIG Tin Total Return Sub-Index ETN (JJT)
• iPath Dow Jones AIG Platimun ETN Total Return Sub-Index (PG)
• iPath Dow Jones AIG Lead ETN Total Return Sub-Index (LD)
• iPath Dow Jones AIG Aluminum Total Return Sub-Index (JJU). 

Note that as unsecured debt instruments, ETNs carry some level of issuer credit risk.