Unlike other products now on the U.S. market, a new family of proposed ETFs from ProShares that is focused on credit default swaps (CDSs) will allow U.S. investors a "pure play" to weigh in on credit quality for the first time.
Bond issuers, especially low-credit issuers, have benefited immensely from the Federal Reserve’s low-rate policy as yield-starved investors have crept down the credit spectrum in search of real return. It’s not just U.S. companies that have loaded up on debt either, “global bond issuance is up a stunning 53 percent from the same period in 2012,” according to CNBC.
But after a long sustained upward move in bond prices, some are nervous this beast might turn around to bite them. ProShares’ filing seems to capitalize on investor anxiety and be an attempt to placate it.
The documents filed with the SEC outline plans for eight CDS ETFs that offer long or short positions on the credit of either investment-grade or high-yield issuers in Europe and North America. They’re unique because, if brought to market, they would offer the most direct way to play credit risk.
The eight ETFs referenced in the filing are as follows:
ProShares CDS Long North American HY Credit ETF
ProShares CDS Short North American HY Credit ETF
ProShares CDS Long North American IG Credit ETF
ProShares CDS Short North American IG Credit ETF
ProShares CDS Long European HY Credit ETF
ProShares CDS Short European HY Credit ETF
ProShares CDS Long European IG Credit ETF
ProShares CDS Short European IG Credit ETF
The filing is timely too:Bond prices appear at the ready to crash downward if Ben Bernanke simply utters “taper” one more time.
Since the crash of 2008, well-rated and poorly rated companies alike have exploited the opportunity to borrow money at ultra-low rates, but one has to wonder if a day of reckoning is coming.
After all, many of these companies are borrowing at near-record low spreads over risk-free Treasury securities—a trend that is bound to reverse.
One glance at a chart of how the cost of borrowing has dropped drastically over the past three years makes it obvious why so many companies, especially the less creditworthy, have loaded up on cheap debt. Check out the effective yield on high-yield (junk) bonds, which we can use a proxy for borrowing cost:
At least in the short term, it’s great for those companies that have been able to pay so little to borrow money. In turn, they’ve been able to undertake projects and investments that otherwise would not be profitable.
However, much like overleveraged homeowners leading up to the financial crisis, corporate executives can be—and often have the incentive to be—shortsighted in the sustainability of borrowing.
The problem is that much of the debt being issued will be paid down by issuing more debt. That can quickly become a vicious cycle if the cost of borrowing rises.
How would the ETFs work?
Each ETF is either a buyer—who is long the CDS and short credit quality; or a seller who is short the CDS and long credit quality—of index-based credit default swaps. The indexes vary by region and credit quality, but the long North American high-yield ETF would track a Markit index of 100 of the most liquid North American issuers that are rated below BBB-.
If brought to market, these ETFs would be the most direct way to play credit in an ETF.
Other funds, such as the Market Vectors Treasury-Hedged High Yield Bond (THHY) and the ProShares High Yield Interest Rate Hedged ETF (HYHG), have the same end-goal of credit exposure but don’t fully hedge interest-rate risk. Both strategies attempt to hedge out interest-rate risk by shorting Treasurys, but basis risk lingers and investors are still slightly exposed to interest-rate risk.
It may seem a bit counterintuitive, but the ProShares CDS Long North American HY Credit ETF would be short CDS contracts on high-yield North American issuers. That’s because it’s actually long the credit quality of North American high-yield issuers.
So if you caught my drift earlier about overleveraged high-yield issuers, take a look at the ProShares CDS short high yield ETFs. These funds stand to gain from credit-quality deterioration among high-yield issuers.
If ProShares brings these ETFs to market, which appears likely, they would be the first CDS ETFs to trade in the United States. As such, a few words of caution regarding credit default swaps are in order.
First, because they are swaps, they bear counterparty risk. If you’re long the CDS—and short credit quality—keep in mind that if your positioning is correct, the credit quality of your counterparty may well deteriorate congruously with the companies whose credit you’re shorting.
Second, remember that a “credit event” must be determined to be such by the International Swaps and Derivatives Association.
If you remember Greece a year ago, there was skepticism as to whether the mandatory haircuts placed on Greek debt would actually qualify as a “credit event.” Fortunately, for the sake of the CDS market, ISDA did deem the action a “credit event” and sellers of credit default swaps were forced to make their buyers whole.
Still, remember that it’s not all black and white, and there is an association that stands between a perceived credit event and an actual “credit event” as determined by the ISDA.
Ultimately, ProShares’ ETFs—if they launch—would be the first CDS ETFs to trade in the United States.
They would offer the only way to directly (and exclusively) play credit quality via an ETF, which, in light of the current investment environment, could be hugely valuable to some investors.
At the time this article was written, the author held no positions in the securities mentioned. Contact Spencer Bogart at email@example.com or follow him on Twitter @Milton_VonMises.
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