A Primer On Exchange Traded Debt

by: Shreya Mathur


ETD, or exchange traded corporate debt, provides attractive investment opportunities for an income investor.

ETD has a host of risks which should be fully appreciated, including credit, interest rate, liquidity, reinvestment, and call risks.

Investors should invest in ETD based on their risk tolerance and income requirements, and understand the difference between ETD and traditional corporate debt.

For any of you who may have read my previous post on Exchange Traded Debt (ETD), you will see that this article is my way of taking ownership for my writing. The main goal of this article is to provide significant revisions to the previous analysis and create a base for concise, comprehensive information on the features, risks, and applications of ETD. From the comments on the previous article, it was clear that this is an investment class that is underutilized, and perhaps even a little misunderstood. While this article is not supposed to be exhaustive by any means, it can be considered an acceptable starting point for the average investor.

Let's dive in…

The Nature of Exchange Traded Debt

ETD is a type of debt security that is exchange-traded, instead of trading on the over-the-counter market like most traditional debt. Instead of having typical bond par values of $1000 and making semiannual coupon payments, these securities usually have a par value of $25 and make quarterly interest payments; the payments from ETD are considered as interest under US tax law, and are taxed at the ordinary income level - payments do not fall under the qualified dividends category. They tend to have long maturities, but call options within 5-10 years of issuance. ETD may be senior, subordinated, or junior unsecured debt - the specific issue prospectus will detail the exact ranking within the company's capital structure. As a result, they are senior to equity and most often senior to preferred stock (due to their $25 par nature, they are often confused with preferred stock), as the capital structure chart below will illustrate.

In general, though, ETD can provide a fine alternative to preferred and common stock for a conservative income investor looking for a decent yield with lower risk than a stock purchase.

It is also worthwhile to be aware of the way that ETD trades. ETD trades "dirty", or with the accrued interest embedded in the price. One way to get a better feel for the "true" yield on the security is to back out the accrued interest [($25 x rate) / (365 x # of days since the last payment)] and arrive at a "stripped" price and the resulting "stripped" yield. This allows an apples-to-apples comparison between multiple issues that have different rates and payment dates.

Investors should be careful to note that ETD is not the same as Exchange Traded Notes (ETNs), which are also traded on exchanges but are structured debt products that track an index.

Risks of Exchange Traded Debt:

Like any form of corporate debt, ETD comes with its own set of risks. They are discussed below:

1.Credit Risk: Since ETD is a form of corporate debt, credit risk is the most obvious risk to be concerned with. Conservative investors may want to choose from investment-grade (IG) issuers, though there are high-yield choices available. However, it is important to dig deeper than just the debt rating of the specific debt issue. In some cases, the debt rating may be investment-grade, but the underlying company may slowly be showing signs of distress. A good rule of thumb would be to consider stable, established companies, or be ready to study the company's financials and do some old-school credit analysis.

2.Interest Rate Risk: All forms of debt are subject to interest rate risk. There is an inverse relationship between the price of a debt security and interest rates. As interest rates rise, the price of a bond falls, and as interest rates fall, the price of the bond increases. The reason for this is that when interest rates rise, the income stream (as well as the principal) must be discounted at the new, higher rate, causing the present value of those streams (the bond price) to fall. Alternative forms of interest rate products can become more attractive in such a scenario (e.g. CDs, treasuries, etc.). If interest rates rise higher than the coupon rate of a security, an investor can expect a fall in its price. Interest rate risk is higher in long dated debt securities, as a longer series of cash flows reprice in changing interest rate environments. Such interest rate risk is applicable to ETD as well.

Note: Treasury yields were obtained from the Treasury website, and GSJ and AVV historical prices were obtained from Yahoo Finance.

Interest rate risk is well-exhibited in the charts above. As can be seen, when the 20-year and 30-year treasury yields rose late last summer (due to the taper tantrum), ETD securities lost anywhere between 10% to 12% of their trading price in response. As such, investors should be strongly aware of this behavior when considering an investment in debt securities.

3. Call Risk: Most ETD has a call date, which means the issues can be called on or after that date at the call price of $25. This is more of a concern if the security is purchased at a premium above $25. In that case, there will be a loss of capital when the issue is called (which is reflected in the yield-to-call of the issue). However, if the security was purchased at a discount, a call of the security will lead to a proportional capital gain. Note, however, that an issue is only likely to be called if the issuer believes it will be able to refinance its debt at a better rate in the current and long-term economic environment. The call option is beneficial for the issuer, not the investor.

4. Liquidity Risk: ETD is not as heavily traded as stock issues, and an investor should try to invest in ETD that have higher trading volume so as to be able to trade in a tighter bid-ask spread environment and easily sell if necessary.

5. Reinvestment Risk: Any time an investor does a yield to maturity (YTM) calculation, it is assumed that any interest earned during the life of the security is reinvested at the same rate as the original capital to earn the calculated YTM. In reality, this does not happen often. Trading costs, changing rate and/or risk premium environments, and partial or no reinvestment of interest income can lead to lower yields than the calculated YTM. Furthermore, it may not be possible to reinvest interest income at the same rate as the original capital. For an investor who is looking to just measure interest income, current yield may be helpful. Current yield is just the interest received in a year, divided by the market price.

How to Choose an ETD Security:

A complete listing of ETD securities on the NYSE, along with links to security prospectuses can be found on The Yield Hunter and QuantumOnline. To start with, I narrowed down the list of securities based on their debt rating and maturity date. These two factors consider credit risk and interest rate risk. I chose only investment-grade securities with the latest maturity year of 2043 (while going out to 2043 is still long term [29 years] and subject to significant interest rate risk, it does merit consideration when one's goal is to generate income). Next, in order to address call risk, I chose securities that had call dates of 2016 or later. I also ensured that none of the securities were non-cumulative. After that, I narrowed down the list further to those securities that had a coupon rate of 5.5% or higher. Below is the list:

Note: While this table is limited to securities maturing up till 2043, with the exception of Verizon (NYSE:VZ) (for a specific case study, see here), there are some attractive opportunities for later years (e.g. Goldman Sachs's (NYSE:GS) 6.5% notes due in 2061 with a first call date in 2016 - ETD ticker of GSJ) that one may want to consider. All price and yield information is as of market prices on March 14th, 2014.

My next step was to consider the current trading prices, liquidity (via bid-ask spreads and trading volume in the market), and the prospectuses of the above securities. The prospectuses were helpful to know where the securities fell in the capital structure of the firm, and if the security paid in arrears with compounded interest on top of deferred interest (and how many consecutive deferrals are considered a default).

Note: All price and volume information is as of March 14th, 2014.

At this point, an investor could choose to invest in a security depending on his/her risk tolerance and income requirements. I will not make any specific recommendation here, but as can be seen above, I have listed the points to consider before making a purchase.

When to Buy an ETD Security

One of the most crucial questions that got asked in the comment section of my previous article was when to buy the ETD. Should ETD be purchased in a low or high-interest rate environment? To be frank, it depends on what the investor's investment goals and return objectives are. One could choose to be conservative and purchase a security only when it is trading at a discount (so that call risk is minimized in terms of capital loss), but will still be subject to credit and interest rate risk. However, if an investor intends to hold the security to maturity (especially for income-producing or retiree portfolios) and would like a capital loss tax write-off (or is an offshore investor), it might be in the said investor's better interest to buy the security at a slight premium or at par (as long as the interest income is enough to offset the capital loss). While many investors do not like to purchase securities above par, the yield to call on the security can help define whether an above-par purchase still fits within the investor's objective. The investor's interest rate outlook can help her determine if the likelihood of a call is high.

Lastly, for those who are interested in maintaining an income portfolio, ETD can provide attractive opportunities as well as diversification benefits.

ETD vs. Corporate Debt in the Debt Market

ETD is structurally the same as 'traditional' corporate debt. There are a few differences, however. ETD is more accessible to the average or non-institutional investor by being exchange-traded. Also, ETD does not have a minimum purchase requirement, has a lower bid-ask spread (in comparison to the rates that a retail investor would receive in the bond market, which is geared toward institutional or larger investors). However, unlike some of the debt in the debt market, ETD is unsecured and is not the most senior form of debt, but usually still ranks higher than equity.

Another interesting point is that ETD (usually) has more protection for the holder than preferred stock. These protections can include redemption at par value in the event of a change in company ownership, and as briefly mentioned above - compounded interest payment in arrears in case of deferrals. In most cases, consistent deferral for five years results in filing for bankruptcy (once again leading into credit risk). However, there can be variations, and an investor should carefully study the prospectus before investing.

Learning More About ETD:

One can learn more about ETD by reading the prospectus of any ETD security (to better gauge the general characteristics of the security), by referring to the two websites mentioned previously, and by doing thorough research on similar income-producing securities like trust preferreds and preferred stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am long AVV. Furthermore, I am not a registered investment advisor; no part of the article is investment advice. This article is for informational purposes only and is not a recommendation to buy or sell any security. Please do your own research and due diligence and research before investing.