Rethinking ETN Credit Risk

July 03, 2012

Investors expect to get compensated for taking more risk. Are ETNs held to a different standard?

Exchange-traded notes don’t pay any yield for the risk baked into their bondlike structure. They do, however, deliver the returns of their target index magnificently with no tracking error.

And that was always the trade-off: “Hey, I’m willing to bear the counterparty risk in return for great tracking.”

ETNs can hold other attractions beyond great tracking. Some have tax advantages, and for certain assets, ETNs are the only game in town.

But that trade-off between counterparty risk and ETN advantages may need to be revisited in view of recent credit downgrades to of a number of ETN issuers.

Another term for counterparty risk is credit risk, and credit ratings for major banks were downgraded recently by Moody’s.

Wall Street generally yawned at the news, saying that the ratings agency was simply waking up to the tough reality that banks have faced for some time.

Still, watching the ratings sink toward junk status made me think about ETNs.

After all, an ETN is just a note issued by a bank, backed by a promise to pay. A corporate bond too is backed by the issuer’s promise to pay, and part of its yield is compensation for the risk that issuer might default.

Corporate bonds include risks beyond just the issuer’s credit risk, such as interest rate risk and inflation.

One way to look at credit risk is to take the difference of a corporate bond’s yield from the yield on a comparable Treasury security. Since a Treasury’s yield accounts for interest rate risk and inflation but in theory has no credit risk, the difference of the two captures credit risk.

Here’s a look at the credit spreads over Treasurys for Morgan Stanley, an ETN-issuer that was recently downgraded. (My colleague Gene Koyfman kindly gathered the Bloomberg data for me; any errors in analysis are mine.)

Corporate Financial Bond Spreads

For a two-year Morgan Stanley bond, investors require 3.5 percent of yield solely for credit risk.

Yet holders of ETNs underwritten by Morgan Stanley aren’t getting any compensation as it relates to any credit risk associated with the big investment bank.

I’m not picking on Morgan Stanley. Credit Suisse, Deutsche Bank, UBS and Barclays were recently downgraded as well—and Barclays has its own particular struggles now with its involvement in Libor-fixing.

Credit default swaps may be a more accurate measure of credit risk, but looking at ETN counterparty risk from a yield point of view strikes me as more intuitive.

After all, few of us buy insurance for $10 million of debt over five years, which is the basis for a pure-vanilla CDS contract.

But most of us own bonds in some manner, and many of us may even be bond issuers ourselves in the form of a mortgage. So we have a horse sense about rates and yields.

So take a moment to reconsider credit risk for any ETN that you hold or plan to buy to make sure that the trade-offs of the structure still make sense for you.

 

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