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

 

 

As the European sovereign debt crisis continues, all the major ETN backers have seen rallies in the prices of credit default swaps traded on their debt.

The most striking however, is that of Morgan Stanley which rose more than tenfold since early summer and surpassed our threshold of 500 bps, above which we start paying close attention. To quickly review, Morgan Stanley is rumored to be exposed to French banks, which themselves hold significant amounts of Greek sovereign debt.

This tenfold rise, which basically means that someone holding $1 million of Morgan Stanley’s one-year debt will have to pay over 6% percent a year, or $60,000, to insure it, should be a wakeup call to those holding Van Eck ETNs backed by Morgan Stanley. Among them are the Market Vectors Chinese Renminbi ETN (NYSEArca: CNY) or the Market Vectors Double Short Euro ETN (NYSEArca: DRR).

Though it seems that holding securities shorting the euro or giving you access to the Chinese renminbi may help you weather the crisis—the fact that Morgan Stanley might be overexposed to the crisis directly affects the value of your securities.

Even in the case where credit-rating agencies are proactive in downgrading debt, investors should still be cautious.

Despite the lack of readily available data on RBS one-year CDS rates between July and September, one can still note that the recent levels of rates are still significantly higher than those last reported in July.

Even though Moody’s was quick to downgrade RBS’s debt, this came nearly two weeks after the cost to insure RBS’s debt was in the range of 280-300 basis point, up from around 126 in early July.

Backing Issuer Total ETN
AUM ($, MM)
Barclays 6,938.67
JP Morgan 2,884.17
Swedish Export Credit Corp-SEK 1,336.02
Deutsche Bank 1,223.88
Credit Suisse 871.41
UBS 823.09
Morgan Stanley 197.31
RBS 92.49
Goldman Sachs 71.08
HSBC 36.70
Citigroup 19.25

On the macro scale, Morgan Stanley is still a smaller player in the ETN space. As shown above, Barclays is the dominant force. Regardless, as the markets continue in uncertainty, investors should take note of their exposure behind the scenes.

 

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