A week after an explosion of volatility forced Credit Suisse to close its VelocityShares XIV short-volatility ETP following a -90% “termination event” – wiping out millions of dollars of retail traders’ profits (though a floor was placed under tumbling CS shares after the company’s comms department disclosed that the bank was “completely hedged”) – Citigroup and Goldman Sachs Group are already seeking to capitalize on “pent up” retail interest in the next big thing to blow up, by launching an ETF that tracks European riskiest bank debt, according to Bloomberg.
The funds would focus on AT1 notes, a category of bonds that includes the infamous contingent convertible – or “CoCo” – bonds that famously played into the panic surrounding Deutsche Bank shares during the summer and fall of 2016. These bonds are unsecured and during bail-ins and restructurings are exchanged for (typically far less valuable) equity if a bank’s ability to absorb capital losses falls below a certain threshold.
The risk associated with these bonds was on display last year when Banco Santander SA absorbed the insolvent Banco Popular Espanol, destroying 100% of junior bondholders’ principal overnight.
As we noted at the time, these AT1 bonds had the distinction of being the first to be bailed in/wiped out under new EU regulations…leaving holders with nothing.
And now, retail investors will have the option to get even more intimately familiar with the potentially implosive debt, thanks to Citi and Goldman who are marketing the funds as allowing retail investors to access one of the highest-yielding asset classes of the past year. But – like the short-volatility trade – these bonds can evaporate in an instant, wreaking havoc in the course of a day.
Citi met with investors this year to promote an ETF that will track an index of additional Tier 1 notes, said the people, who asked not to be identified because the information isn’t public. Goldman is working with an issuer to offer a similar product, while China Post Global, the international asset-management unit of China Post & Capital Fund Management Co., is also preparing an AT1 fund, the people said.
ETFs linked to AT1 bonds will broaden access to one of the best-performing and highest-yielding asset classes of the past year. In 2017, the notes rewarded investors with a 14 percent gain, according to the ICE BofAML Contingent Capital Index, about twice the return on high-yield corporate bonds.
Furthermore, since retail investors tend to be notoriously skittish when markets are in turmoil, analysts worry that placing these “assets” in an ETP wrapper that can be easily traded intraday might actually accelerate the volatility of the underlying assets.
That could be a problem, according to Philippe Kellerhals, a portfolio manager at Cairn Capital, which oversees $3.4 billion. A broader audience may mean more retail investors who can be more skittish than their institutional counterparts, raising the possibility of higher volatility.
“The big difference is that ETFs are listed, so the investors getting involved may be different,” he said. “The risk is that when sentiment changes, the ETFs could accelerate price volatility.”
Meanwhile, some of the most popular ETFs suffered historic outflows following last week’s events, with investors pulling record amounts from the S&P tracking SPY ETF.
Of course, as Bloomberg points out, investors can already gain exposure to the AT1 market. Last year Goldman Sachs and JPMorgan Chase & Co. started making markets in total-return swaps, which can be used to bet against the AT1 bonds or to hedge existing positions. But these products don’t have the same appeal to retail traders that an ETF would.
And since these bonds, like the VIX, would be prone to intense bouts of volatility, retail traders could easily be lulled into a false sense of security, only to see their principal vanish in the span of a day when the next debt crisis envelopes the European banking system.
But there’s another reason why Citi and Goldman are probably considering trying to bring this risky debt to the masses: Europe’s strict post-crisis capital requirements are making them increasingly popular with issuing banks…
… and who better to sop up all that supply than a bunch of yield-starved retail investors clicking the “buy” button all day long on E*trade.