Seeking Alpha
, Think Finance (819 clicks)
Long/short equity, arbitrage, event-driven, research analyst
Profile| Send Message|
( followers)  

Wouldn't it be nice if a corporation could issue some kind of debt, and have this debt go lower and lower in value until it became nearly worthless, without the issuing corporation having to default? And having a way of doing this legally to boot? As in, getting borrowed money and never having to pay it back?

This was exactly what happened with VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX), among other similar levered ETNs. An ETN is an "Exchange Traded Note," or to put it another way, it's simply debt. But this particular debt, which has a maturity like any other note/bond, has its notional amount -- the amount that it will pay at maturity -- tied to the 2X daily levered performance of a basket of futures. And that's where the magic happens.

The "magic" as it stands, was already laid out in the prospectus when this instrument first came to market. These were the words explaining it (page 28, PS-28) (bold and underline not mine -- it's exactly like that in the prospectus):

The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.

Read that again. An ETN is a note/bond/debt from the issuer. As most debt, at maturity the issuer usually faces a balloon payment accounting for the notional of the note/bond. Yet here, the debt note is designed in such a way that the long term expected value of the instrument is zero. That is, this is borrowed money whose long term repayment trends towards zero! Free money!

Was that free money for the issuer?

It might seem that way. But it's not guaranteed. It depends. It depends on whether the issuer decided to hedge the daily fluctuations on the instrument by using the underlying futures. Were the issuer to do so, and much of that free money would end up in other people's hands, because one of the reasons why TVIX trends towards zero is the heavy contango it systematically faces in the TVIX futures, leading to losses for TVIX on each rollover of those same futures.

So the answer here is, we don't know who kept the money. Though, in designing the ETN with full conscience that the long term expected value was zero, it's quite possible that the issuer kept a good chunk of it.

Notwithstanding, the implications are clear

Never mind who keeps the money. The fact is that these things -- and I am talking about any similarly levered ETNs dabbling in contango-prone futures - are designed to fall. So, for the most part any sane investor will do good to steer clear of them. Forget the "only for short-term purposes" and simply never buy these things. The danger of getting caught in them, and then psychologically grabbing on to hope as the money vanishes is simply too big.

Conclusion

It's not the first time I've warned about TVIX and other similar products. However, given the danger presented by them -- so well illustrated by TVIX's trajectory -- I felt it's not too much to remind investors again that ETN's such as TVIX are debt designed to go to zero. Don't be the one holding the zero.

Source: TVIX: Don't Be Left Holding The Zero