News that Deutsche Bank is in serious financial trouble has roiled global markets in recent days, and thus far, European leaders have signaled little desire to step in and save the troubled bank.
In the world of exchange-traded products, Deutsche Bank is the underwriting bank of 20 exchange-traded notes, with more than $700 million in combined assets.
If Deutsche fails, what happens to these investment vehicles?
ETNs are debt securities issued by a bank that are senior, unsecured—meaning, they have no collateral—and unsubordinated. When you buy an ETN, the bank delivers you the return of an index minus fees.
But the crucial aspect of an ETN, particularly in light of Deutsche’s troubles, is that its very survival hinges on the bank’s ability to meet its financial obligations. An ETN is directly linked to a bank’s creditworthiness.
Ron Rowland, portfolio manager at Flexible Plan Investments, made headlines this week suggesting investors should sell Deutsche ETNs before it’s too late. In his blog, he pointed out that “legitimate concerns” about Deutsche’s financial viability have surfaced as the bank’s stock price plummeted to levels lower than those seen in 2008.
“DB probably falls into the ‘too big to fail’ bucket among European financial institutions, but what if it’s not?” Rowland said. “If DB has borrowed money from you, then you should be concerned. If you own DB ETNs, then DB has borrowed money from you, and your loan to DB is not secured with any collateral. Your best recourse at this time is to sell your DB ETNs before such a risk materializes.”
The question investors face is, how serious is the risk at this point? In Rowland’s eyes, very serious.
We can’t forget what happened when Lehman Brothers collapsed in 2008. Lehman was the issuer behind three ETNs, and investors in those strategies “were left holding the bag,” Rowland said. In other words, if a bank goes bankrupt and you didn’t get out of that ETN ahead of time, you will probably lose your money.
ETNs Can Be Senior Debt
But some ETF analysts argue that it’s still too soon to panic. In the capital structure of a bank, ETNs rank as high as other senior debt—those that, at least in theory, must be paid off first in the case of bankruptcy.
And DB’s ETN footprint isn’t all that massive, totaling about $700 million in ETN assets.
The good news is that getting out of an ETN—and getting fair value for it—isn’t that difficult. Investors and institutions can redeem ETNs on a daily basis.
“Credit risk in most situations is very minor,” according to ETF.com research. “While anything can happen, you can usually see major bank defaults coming more than a day or two ahead of time.”
‘Credit Risk Is Easily Monitored’
Also good news is the fact that “credit risk is easily monitored.” That monitoring is done via credit default swaps, and ETF.com Analytics tracks these spreads closely, and reports on an ETN’s counterparty risk regularly—the risk of default.
If you look at the fund reports on ETF.com for DB’s three largest ETNs (see table below), their respective counterparty risk is currently assessed as “medium.” Low would certainly be ideal, but that risk is not yet high. If that risk metric gets changed to “high,” consider that your cue to sell.
You can find counterparty risk assessment for each ETN in their respective fund pages, linked below for each strategy.
The ETNs in question include:
Contact Cinthia Murphy at [email protected]