Nadig: Finally, Credit Default Swap ETFs

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.

Not Your Typical Index

The CDX index that these ETFs are using (not tracked, because these are technically actively managed) isn’t like a typical index. It doesn’t own the credit default swaps of a pile of junk bond issuers.

Instead, it creates a new index based on a notional security that looks like a bond that’s made up of equal weights of 100 issuers. It sets a flat coupon payment (currently 5 percent) that’s paid from the buyer of protection to the seller of the protection.

The actual value of the CDX is computed like the price of a bond; that is, if the average spread of the CDS in the reference basket goes up, the value of CDX goes down (because the payment is fixed at 5 percent). If the average spread in the basket goes down, the value of CDX—just like the price of a bond—goes up.

So where does the default part come in? If any of the referenced bonds have any kind of adverse credit event, the index is closed and reconstituted. The sellers settle up with the buyers, and a whole new index is relaunched with a new base price derived from a fixed coupon (currently 5 percent), and it all starts over again.

If there’s no credit event, a new index is still remade every six months. So in a very real sense, there’s no one index; there are in fact 22 indexes (the number of series since the CDX was launched) and several versions of many series (as a new version is set anytime there’s a default.)

Wacky World Of Derivatives

Welcome to the wonderful and wacky world of derivatives. And also, welcome to why this really does need to be actively managed. As each new series of the CDX comes out, someone will have to make the call on which series to be invested in and when to make the switch.

That may sound mechanical, but the liquidity doesn’t automatically just float to the next series in a single day. If it did, you could easily construct a second-order index that treated each CDX series essentially as an expiring futures contract, and rolled from one to the next.

But there are nuances that actually require a bit of thought. And if ProShares gets really good at this, maybe it will use the latitude it has in the prospectus to actually make an index, and then track it. That’d be swell.

As confusing as all this sounds, the market for CDX swaps is in fact enormously efficient, with several billion dollars changing hands on the CME over-the-counter market every day.

Are these products the average buy-and-hold investor is going to use? Hardly. But they do offer some interesting hedging and even income-generation tools for sophisticated investors.

The short side offers a new way to bet on catastrophe that doesn’t involve directly shorting an asset class. The long side offers a way to generate income from low-volatility, low-stress corporate bond markets.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].