Swedroe: An ETN Credit-Risk Reality Check
The financial crisis of 2008 put a spotlight on the role of credit risk in many investments.
While counterparty risk has been in the spotlight with such derivatives as credit default swaps, very little attention has been focused on their role in exchange-traded notes (ETNs).
An ETN is a tracking product that is designed as an unsecured debt security and is therefore subject to the issuer’s default risk. ETNs are relatively new, but they are rapidly growing financial vehicles generally issued by a single bank as senior, unsecured, unsubordinated debt securities.
They are backed only by the full faith and credit worthiness of the issuer. As unsecured promissory obligations, ETN holders are directly exposed to the issuer’s credit risk. Unfortunately, many individual investors ignore this risk.
A possible explanation for this mistake is that investors may wrongly lump them together with ETFs, which don’t entail credit risk, as they hold the underlying assets of the index they’re designed to track.
ETNs typically have long maturities, usually more than 30 years from their day of issuance. However, they contain early redemption mechanisms that may also be the cause of investors ignoring the credit risk. Their structure allows dealers to redeem existing units at their current intrinsic value directly with the issuing entity on any given date.
Unfortunately, that doesn’t mean that the early redemption order is executed immediately. The redemption process requires an early notification to the issuing entity, and the redemption value is determined on that date. Investors receive payment several business days later—typically five. During this period, the holder of the ETN is exposed to default risk.
While the redemption option essentially converts ETNs into very-short-term debt securities, it doesn’t imply that credit risk is a negligible, or even theoretical, issue.
AIG, Lehman Brothers and Bear Stearns all had investment-grade ratings at the time of their collapses. Thus, during the financial crisis, credit risk became highly relevant. Lehman’s lineup of Opta ETN securities stopped trading around its time of default, then delisted. Investors eventually recovered just 9 percent of their ETNs.
A similar fate almost hit investors in Bear Stearns’ ETNs. (Fortunately for them, J.P. Morgan honored all Bear Stearns debt obligations.)
With these facts in mind, the authors of a study in the Journal of Fixed Income, “Counterparty Risk in Exchange-Traded Notes,” examined the issue of credit risk in ETNs. Their study focused on the largest ETN issuers that also experience active trading for their CDS contracts:
- Barclays Bank PLC, which issues ETNs under both the iPath and ETN+ brands
- Deutsche Bank AG, which issues ETNs under PowerShares
- Morgan Stanley, which issues ETNs under the Market Vectors brand
- UBS, which issues ETNs under Etracs
Be careful when making fruit-basket comparisons; you’re likely to come up with lemons.
Movers and shakers in the ETF world are often just the opposite.
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