ETFs provide a cheap, easy, and effective way for investors to diversify their portfolios. ETFs exist for almost every asset class imaginable, including asset classes that were previously inaccessible to individual investors. The majority of ETFs are relatively easy to understand, so it is not a significant problem if an investor assumes SPY will track the S&P 500 with a high degree of accuracy. However, when the ETF is not tracking a simple equity index, it becomes essential to understand the underlying mechanics. ProShares recently launched two credit default swap (CDS) ETFs: ProShares CDS North American High Yield Credit ETF (BATS:TYTE) and ProShares CDS Short North American High Yield Credit ETF (BATS:WYDE). Understanding how a CDS works is insufficient to understand the behavior of these funds because the funds do not actually own any CDSs directly. My purpose in this article is to explain the mechanics underlying TYTE and WYDE and to examine what the implications are for investors considering the funds. First, I will address how a CDS works, then I'll discuss how the portfolios underlying TYTE and WYDE are constructed.
The buyer of a CDS is insured against the risk of default by a particular company known as the reference entity. Technically, the insurance is against the risk of a credit event, so sometimes events, such as restructuring may be considered credit events, in addition to default. The buyer will make payments to the seller of the CDS until there is a credit event or the end of the CDS' life, whichever comes first. The buyer of the CDS has the right to sell bonds issued by the reference entity at face value to the seller when a credit event occurs. The total face value of all the bonds covered by the CDS is called the CDS' notional principal. In return for providing insurance, the seller earns periodic payments until there is a credit event or the CDS reaches maturity. The amount the seller of the CDS earns is some percentage of the notional principal every year; the percentage is called the CDS spread.
Obviously, a CDS can be used to hedge a bond position, but unlike normal insurance, the investor does not actually need to own bonds from the reference entity to buy a CDS on its bonds. Another important detail concerns what type of settlement is specified by the contract. If the contract specifies physical settlement, the buyer has the right to sell the bonds for $100 per $100 of face value; in return, the buyer must deliver the bonds to the seller. If the contract specifies physical settlement, an independent agent will find the cheapest deliverable bond within a set number of days of the default. If the cheapest bond trades at $40 per $100 of face value, the cash payoff would be $60 per $100 of notional principal. In the case of a cash settlement, the buyer does not deliver the bonds to the seller, so the buyer can still sell the bonds to make up the rest of their investment principal (Hull, John. Options, Futures and Other Derivatives. 7th ed. Upper Saddle River, N.J.: Pearson Prentice Hall, 2009. Print.).
For my purposes in this article, the most important thing to know about CDS valuation is that valuation requires estimating the default and survival probabilities for the reference entity over the life of the CDS. The details are not necessary to cover in this article, but it should be noted that default probabilities can be approximated using the reference entities bond yields and the corresponding risk-free bond yields. Another method includes using historical default probabilities based on the company's credit rating. In any case, getting this part of the analysis wrong had a lot to do with the reason you would likely know anything about credit default swaps in the first place (see: AIG). I'll return to this concern when looking at possible uses for TYTE and WYDE.
Being long a CDS means that you are selling insurance, while being short the CDS means you are buying the insurance.
If you look at the current holdings of either TYTE or WYDE on the ProShares website, you will see that all of their NAV is, as of writing this article, held in two investments: CDX NA HY Swap Series 21 and Series 22. The CDX North American High Yield credit index (CDX) is somewhat different than other indices in that it does not actually "own" a portfolio of CDS Also, the index components are updated every six months, hence the series number. Every six months, Markit (the index owner) uses a set of rules (documented here) to select 100 companies for the next index series. To be exact, they select a reference obligation (BOND) from each company and add them to the index with equal weight. Markit also sets a coupon rate (currently 5%) that represents what the seller of the insurance is paid by the buyer (annualized). The coupon rate is independent of the CDS spreads on the underlying reference obligations, but the underlying spreads are still essential. Changes in the underlying CDS spreads impact the price of the index in the same way that changing interest rates impact the price of a bond. In general, if the credit market improves and the underlying spreads decline, then the price of the CDX index will increase, similarly, when the conditions in the credit markets worsen, spreads increase and the price of the CDX index declines
Now, consider the current price of the CDX index, if you scroll to the bottom of the page you will notice a table with the current number of components in the index (99, as of writing this). This is where the insurance aspect comes into play. When there is a credit event, those with a long position (sold insurance) will pay the short position in proportion to the weight of the underlying reference obligation in the index. Unlike a standalone CDS, annual payments continue to occur, but they will be reduced because the notional value on the bonds that defaulted is subtracted from the total. This means that the annual payment will still be 5%, but the notional principal is now smaller.
TYTE and WYDE
Now, what does all of this mean for investing in TYTE and WYDE? I'll start with TYTE (prospectus). The greatest potential risk of investing in TYTE is that the reference obligations underlying the CDX index swaps could default. The fund is actively managed, so management can control the average maturity of the underlying swaps and which weight to give each series of CDX index. The rules used for selecting reference obligations for the CDX index specifies under which conditions a reference obligation will be removed from the index (e.g. corporate events, credit events, insufficient outstanding debt, and insufficient liquidity, to name a few examples, see documentation for details). The next series in the index will be made by simply adding reference obligations to replace any that are removed, therefore the majority of the reference obligations will stay in the index.
TYTE currently has two holdings: about 83.5% in Series 22 and the other 16.55% in Series 21. It's not surprising that the fund will own CDSs based from more than one series at a time, but it should be pointed out that this does not greatly diversify the fund's holdings. You can find information about exactly what reference obligations are included in each series at this link. To give you a point of reference, I compare Series 21 and Series 22. There are only four differences in the reference obligations out of 100 total and both series were impacted by the same default (it's in red, second page). One shouldn't assume that, don't think TYTE is safer because it owns more than one series; there's too much overlap between the series.
Keeping in mind that the NAV of the fund can be significantly impacted by a change in credit spreads means that TYTE is not likely a fund for those worried about tail risk. The idea issue of tail risk is related to the problem of estimating the default probabilities for the reference obligations the CDX index is based on. But the problem goes deeper than just finding the right number for any single CDS, with over 100 reference obligations in question, the real issue is the correlation between defaults. The logic for diversification is that the probability of many independent investments all failing at the same time is extremely unlikely. It is highly unlikely that a significant number of the 100 companies in the CDX would simultaneously default (independently). However, extreme situations, such as the financial crisis, can create a self-fulfilling prophecy where an unwillingness to extend credit leads to defaults, which makes it harder to obtain credit. If another crisis of that magnitude occurs, TYTE would see significant losses.
Because WYDE (prospectus) uses the same index as TYTE, most of the points made about TYTE also hold for WYDE. The only difference is that WYDE buys protection rather than selling it. Because WYDE is making payments constantly, its NAV will decay over time unless spreads widen and/or there are defaults on the reference obligations. It is conceivable for WYDE to be used as a hedge for a high yield bond fund, for example. However, it may not be an ideal choice for hedging because it is too broad to effectively hedge individual bonds. For hedging bond ETFs, there are other problems. Consider the chart below showing the CCC and BB adjusted spreads (this is a very rough proxy for the CDS spreads). Unsurprisingly, the CCC spreads have a much higher volatility than the BB spreads. For WYDE to be an effective hedge, it would make sense that the bond portfolio needs to be similar to the reference obligations in the CDX index.
Overall, TYTE and WYDE are not worth the trouble of dealing with their complexity. The risks are difficult to assess, and with a yield of about 3.45% on TYTE, the potential return does not justify the risk. Adding complexity also contributes non-monetary costs such as requiring more time to manage and more opportunities to make mistakes. There are easier ways to hedge and easier ways to generate income. Ultimately, it is hard to see a need for WYDE or TYTE in a long-term investor's portfolio.
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.