CIT Internotes Cause Investor Losses

Wall Street appears to have parlayed bankruptcy fears at CIT Group into a trading bonanza Friday. And surprise, surprise, it came at the expense of mom-and-pop investors.

Hundreds of millions of dollars in CIT Internotes — bonds marketed directly to small-time investors and particularly the elderly — changed hands Friday as rumors of a bankruptcy at CIT panicked small-time investors. In their haste, they left tens of millions of dollars on the table, which were scooped up by bond trading desks, brokers and sophisticated investors.

CIT Internotes were the most actively traded bonds in the U.S. markets Friday, by a huge margin, according to TRACE data collected by retail electronic bond-trading platform BondDesk Group. Traders and brokers took out an average of 6.34% in commissions on each trade — the difference between where the bonds were bought and sold - garnering millions in revenue. That compares with an average of 1.06% on all other trades for the day.

In addition the notes were trading well below the prices garnered for equivalent bonds sold to sophisticated investors. For instance, one issue CIT Internotes due 2016 changed hands Friday at an average of 42 cents on the dollar, while equivalent debt held by large investors traded at 52 cents on the dollar, according to Tradeweb.

To be sure, deals targeted at institutional investors come in large sizes and are easier to buy and sell than offerings targeted at small investors. Therefore, brokers and traders are able to charge more for their services, which amounts to finding another buyer, who is in a position to demand a discount.

Bond trading is a zero sum game, meaning someone paid for Wall Street’s profits. In this case, those people are small bondholders.

Internotes are issued by large firms on a weekly basis and then distributed to small investors through a network of broker-dealers and banks throughout the country. Current active issuers include household names like GE Capital, Goldman Sachs and John Deere Capital, according to Internote underwriter Incapital.

Internotes, specifically, are marketed to elderly investors. One of their key features is a so-called “death put,” which allows the heirs of a bondholder to sell the bonds back the company that issues them at face value if the owner dies.

The feature is meant to limit risk to the bond owner’s family, but it doesn’t consider that the company itself might disappear before the investor does.