A Hybrid That Converts Junk Bonds To Triple A?

Influential Support

McQuown says his eBond will enable investors to jettison their credit risk because the swap, which is essentially a form of insurance, will cover their losses should the debtor fail. To garner such protection now, an investor must purchase a swap separately to cover a bond.

“We’ve finally figured out a way to make a bond default-free,” says McQuown, a partner at eBond Advisors LLC, a New York–based firm that’s producing the new security.

The newfangled instrument, which McQuown developed with fixed-income entrepreneur Richard MacWilliams, has won the support of influential figures in finance.

Nobel Memorial Prize-winning economist Robert Merton and former BlackRock Inc. Vice Chairman Blake Grossman are among the investors in eBond Advisors. And John Reed, the one-time chairman of Citigroup Inc. and the board of trustees at the Massachusetts Institute of Technology, is an adviser to the firm.

Wreaking Havoc

“It’s an important idea that deserves to get off the ground,” says David Booth, co-founder and co-CEO of Dimensional Fund Advisors, an Austin, Texas-based investment firm with $381 billion in assets and another backer of the venture. “The way bonds trade now is abysmal, and if we can make the bond market as liquid and transparent as the stock market, that’s a socially desirable outcome.”

The eBond evokes a long line of inventions that were supposed to tame the markets but instead wrought havoc. In 1998, hedge fund Long-Term Capital Management needed a $3.6 billion bailout from 14 global banks after its mathematical models for government bond arbitrage blew up following Russia’s default. Ten years later, a raft of mortgage-backed securities meant to neutralize risk crashed much of the world’s economy.

John Bogle, the founder of index mutual fund pioneer Vanguard Group Inc. and a champion of no-nonsense investing, has crossed paths with many financial engineers, including McQuown. He’s as skeptical as ever that their work yields lasting benefits for investors.

‘Probably a Genius’

“I liked McQuown, and he’s probably a genius -- I have no problem saying that,” Bogle, 85, says. “But geniuses pursue complexity. Any innovation in the financial field is likely to fail. Most are designed to enrich the sellers and impoverish the buyers.”

Yet McQuown isn’t an alchemist who made his name cooking up toxic securities. He actually shares Bogle’s passion for open, cost-efficient markets.

Forty-four years ago, McQuown applied the theories of economists William Sharpe, Eugene Fama, Fischer Black and Myron Scholes to invent the first equities index portfolio.

The breakthrough helped usher in the era of passive investment in an array of stocks across the market, now the linchpin in many a 401(k) fund. Sharpe, Fama and Scholes were eventually awarded Nobel Memorial Prizes for their work; Black died before he could be honored.