Nadig: Finally, Credit Default Swap ETFs

August 07, 2014

Why you should care about TYTE and WYDE, for all their crazy.

When asked, as I often am, where there is still room for ETF innovation, I’ve been saying “a credit default swap ETF” for a long time. Today ProShares launched a pair of them. The ProShares CDS Short North American HY Credit ETF (WYDE) and the ProShares CDS North American HY Credit ETF (TYTE) started trading today, and I couldn’t be more pleased.

But if ever a pair of ETFs needed a little explanation, it’s this pair. At the core, these products look very simple: the long version (TYTE) just buys the highly liquid swaps on the Markit CDX North American High Yield Index. The short version sells them. The funds charge a pretty reasonable 0.50 percent (after waivers) for actively managed exposure, something nearly required for reasons I’ll explain in a bit.

Sounds simple. The complex part is explaining what the heck that even means. Here’s the “too long, didn’t read” version.

How TYTE & WYDE Work

TYTE is selling insurance to nervous nellies. It will generate income (currently around 3.45 percent), and if credit conditions get even better in the high-yield space (in other words, if the spread between junk bonds and investment-grade bonds gets narrower), then the net asset value of TYTE should go up as well.

WYDE is just the opposite—it will pay out that yield over time (like a short-equity seller owing dividend payments), and will go up in NAV should spreads widen, or should there be some sort of crazy rash of defaults.

To understand how that actually works, however, is a little more complicated.

When we talk about credit default swaps, we most often talk about buying insurance, and indeed, if you’re looking to hedge out the risk of an individual company going bankrupt, that’s exactly what you do: you go into the market, and you pay a premium (call it 2 percent, technically known as the “spread” of the CDS) of a notional bond amount (say, $1 million).

For your $20,000 (paid quarterly), you have a counterparty that will make you whole if that $1 million bond goes bankrupt over some period of time (say, five years). The buyer gets the insurance and makes payments, and the seller has a liability, and collects the checks.

Simple enough. But the way the actual CDX index works is a little different.



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