The Role Of Credit Risk In Exchange-Traded Notes

by: Larry Swedroe


Comparatively little attention has been paid to the role of counterparty risk in exchange-traded notes.

Study: Based on real market quotes, there is no evidence that investors are pricing for substantial credit risk in ETNs.

Investors should be sure to examine not only an ETN's expense ratio, but also the implied cost of its credit risk.

The financial crisis of 2008 underscored the role that credit risk plays in many investments. And while counterparty risk has been in the spotlight with such derivatives as credit default swaps, comparatively little attention is paid to its impact on exchange-traded notes (ETNs), a type of tracking product.

ETNs are relatively new -- but rapidly growing -- financial vehicles generally issued by a single bank as senior, unsecured and unsubordinated debt securities. As such, they are backed only by the full faith and credit worthiness of the issuer. Because ETNs are unsecured promissory obligations, ETN holders are directly exposed to the issuer's credit or default risk. Unfortunately, many individual investors mistakenly ignore this risk. A possible explanation for this oversight is that investors may wrongly lump ETNs together with exchanged-traded funds (ETFs), which don't entail credit risk because they hold the underlying assets of the index they are designed to track.

ETNs typically have long maturities - usually more than 30 years from their day of issuance. However, they also contain an early redemption mechanism, which may be another reason many investors ignore their credit risk. ETNs are structured to allow dealers to redeem existing units at their current intrinsic value directly with the issuing entity on any given date. Unfortunately, that doesn't mean an early redemption order is executed immediately. Rather, the redemption process requires early notification to the issuing entity and the redemption value is determined on that date. Several business days later, typically five, investors receive payment. During this period, the holder of the ETN is exposed to default risk. While the redemption option essentially converts ETNs into very short-term debt securities, that doesn't imply that the credit risk is a negligible, or even theoretical, issue. Both AIG (NYSE:AIG) and Lehman Brothers had investment grade ratings at the time of their collapse. Bear Stearns had an A rating before it was saved from collapse by JPMorgan Chase (NYSE:JPM). Thus, during the financial crisis, credit risk became highly relevant. Lehman's line of Opta ETN securities stopped trading around its time of default, then delisted. Investors eventually recovered just 9 percent of their ETNs. A similar fate almost hit investors in Bear Stearns' ETNs. Fortunately for them, JPMorgan Chase honored all Bear Stearns debt obligations.

With all these facts in mind, the authors of the study "Counterparty Risk in Exchange-Traded Notes (ETNs)," examined the issue of credit risk in ETNs. The study, published last year in The Journal of Fixed Income, focused on large ETN issuers with active trading experience for their credit default swap (CDS) contracts: Barclays Bank PLC (NYSE:BCS), which issues ETNs under iPath; Deutsche Bank AG (NYSE:DB), which issues ETNs under PowerShares; Morgan Stanley (NYSE:MS), which issues ETNs under Market Vectors; and UBS (NYSE:UBS), which issues ETNs under E-TRACS. To estimate the size of the credit default premium that should be required, the authors built a default model and used pricing from the credit default swap market. The following is a summary of their conclusions:

  • There is substantial credit risk that should be priced into ETNs.
  • Based on real market ETN quotes, there is no evidence that investors are pricing for that risk.
  • The study's benchmark model implies extended periods of time where discounts should amount to more than 0.5 percent, with variation depending on the issuing entity and the particular date.

For example, at the height of the financial distress in 2009 and 2011, the study's model estimated theoretical discounts of greater than 1 percent existed for some ETNs. However, ETN quotes rarely indicated evidence for pricing credit risk. In fact, they found that ETNs often traded with positive premiums for extended periods.

These findings suggest that investors in ETNs don't fully understand the product structure and are ignoring major risks. The authors stressed "the need for greater transparency in complex financial products and the disclosure of unambiguous measures to gauge embedded risks. Such transparency could better equip investors to understand the complexity of such products and consequently to make better decisions regarding their risks." To that end, they cited the Israel Securities Authority (ISA) as a role model for the regulation of ETFs. The ISA requires that all ETN proceeds must be isolated from the issuer's general capital and deposited in a special purpose vehicle (SPV) with a dedicated external trustee overseeing its activity. Additionally, each ETN must file monthly, quarterly and annual reports that provide a detailed description of how the proceeds are managed and specify sources of potential risk. Both market risk and counterparty credit risk factors are addressed in these reports, along with quantitative measures to gauge them.

Investors in general -- and regulators -- appear to be ignoring the credit risk inherent in ETNs. Investors may be mistakenly treating the unlikely as the impossible, despite recent history demonstrating otherwise). Don't make the same mistake. When considering whether to invest in an ETN, be sure to examine not only its expense ratio, but also the implied cost of the credit risk. Just because you don't receive a bill for that implied cost doesn't mean you aren't taking the risk.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.