An ETN Credit Risk Checkup

October 13, 2011

After last week’s downgrade of RBS by Moody’s, I have to ask , is that the best means of determining credit risk for ETN investors?

Despite what some may have you believe, there are times when ETNs can do a great job of giving investors exposure to a particular segment of the market that ETFs would be unable to access.

However, there still lies one obvious risk when it comes to ETNs- namely the credit risk of the issuer. Because ETNs are structured, unsecured debt securities, their value relies on the fact of whether or not the issuer will exist tomorrow. Herein lies the dilemma with ETN investors: How does one assess credit risk?

It’s been generally accepted that third-party credit ratings from the likes of Moody’s or S&P are the primary source of assessing a company’s credit risk. However, after 2008, we should all know and understand the shortcomings of rating agencies.

It’s no secret that the issuing parties pay the rating agencies to rate their debt, creating a very questionable conflict of interest. Even with that, it still seems that the ratings agencies are the 12th man on the deal team when it comes to alerting investors.

After many hours of debating on the subject here at IndexUniverse, we’ve settled on using credit default swap prices as a proxy for determining credit risk.

Of course, like the credit ratings, there are flaws with CDS pricing. Because the swaps are traded over the counter, volume is difficult to gauge. Hence, it’s hard to tell when there is a “true level” of price discovery. However, having the market’s input is still valuable when compared to relying solely on credit ratings.

In the case of ETN issuers, CDS rates have sent out warning shots in the past few weeks.

ETNs-and-CDS-Graph-2
Source: Bloomberg

 

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