Yesterday morning's news presents some very interesting possibilities. Not interesting in a good way, mind you. As in the ancient curse, you're living in interesting, not good, times. Piling on to the recent scrum in the credit markets, Moody's Investors Service has downgraded Barclays plc's debt to Aa3 from Aa1. The relegation follows on the heels of the bank's announcement of some $12 billion in write-downs.
This naturally worries the holders of Barclays debt. Most keenly dismayed by the downgrade are owners of the iPath commodity index exchange-traded notes [ETNs]. There are a lot of those. Owners, I mean. With 30.4 million notes outstanding, the iPath Dow Jones-AIG Commodity Index ETN (NYSE Arca: DJP) is the most active broad-based commodity ETN extant. An average 800,000 DJP notes change hands every day. In addition to DJP, there's a universe of 20 other iPath commodity products representing a float of more than 35 million notes.
The innate fear of any note holder, of course, is issuer default. Credit rating downgrades often precede such events, but not always. Now, the two-rung descent taken by Barclays doesn't imply imminent collapse, but it nonetheless is a wobble.
Keep in mind that the ETNs issued by Barclays are unsecured. That is, these notes don't have claim against particular bank assets. They're senior debt, to be sure, but the ETNs are on par with all other senior notes issued by the bank. That's a lot of competition for the bank's liquidation value.
A full-blown default, remote as it may still seem, could make the iPath ETNs functionally worthless. But Barclays' teetering is already having an effect on ETN pricing.
One of the oft-touted advantages of ETNs is their lack of tracking error. Since an ETN doesn't rely upon physical assets for valuation, there are no frictional transaction costs embedded. An ETN's notional value is derived directly from the underlying index.
The rubber hits the real-world road, however, when market makers post bids and offers for the notes. When perceived risks enlarge, the inside market widens; that is, the spread between the best bid and best offer gets larger.
And that's what we've seen in the DJP notes. Typically, the spread's only a penny wide. On news of the Barclays downgrade, spreads widened to two, three and four pennies. That may not sound like much, but it is significant. And it could be the start of a trend.
These are not pennies from heaven.