An ETN Primer: Buyer Beware of Even Good Credit Ratings
Exchange traded note [ETN] counter-party risk sounded like an academic concept to some readers when we wrote approximately a year ago about the need to take that risk into consideration when buying ETNs.
Since that time, numerous advisors and authors have identified counter-party risk as a checklist item to research when buying ETNs.
Well, today the chickens have come home to roost.
There are 10 financial institutions issuing ETNs (basically long-term debt, paying no interest, with maturity value that varies with some external index).
One of those institutions is Lehman Brothers (LEH) — now bankrupt.
Many investors may have a false sense of security, since the bankruptcy of an investment advisor to a fund does not imperil the fund’s assets, but an ETN is not a fund. It is a promise to pay by the issuer. The ETN investor is a general creditor of the issuer.
That means that investors who bought Opta ETNs issued by Lehman need to get in line to collect what they can through the bankruptcy courts.
We are not saying the sky is falling, but we are saying ETNs are not as wonderful as they first seemed, now that we are in a global financial meltdown.
Let’s shed some light on this corner of the investment world.
Here are the 10 ETN issuers to the US market along with their Moody’s “bond implied” credit rating and the name of the series under which they issue ETNs. They are listed from highest to lowest credit rating.
- Swedish Export Bank (Aa1) - Elements
- Deutsche Bank (DB) (Aa2) - Elements and Powershares
- Barclay’s Bank (BCS) (A2) - iPath
- Credit Suisse (CS) (A3) - Elements
- Goldman Sachs (GS) (A3) - GS Connect
- HSBC (HBC) ((Baa1) - Elements
- UBS (UBS) (Baa2) - e-Tracs
- Bear Stearns (Baa2) - BearLinx (owned by JP Morgan (JPM) (A2))
- Morgan Stanley (MS) (Baa3) - MarketVectors
- Lehman Brothers (LEH) (B3) - Opta
The Moody’s rating scale is as follows :
Investment Grade
- Aaa
- Aa 1, 2 or 3
- A 1, 2 or 3
- Baa 1, 2 or 3
Below Investment Grade
- Ba 1, 2 or 3
- B 1, 2 or 3
- Caa 1, 2 or 3
- Ca 1, 2 or 3
- C
For the numeric rating 1 is better and 3 is worse.
Moody’s Long-Term Rating Definitions:
- Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.
- Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
- A Obligations rated A are considered upper-medium grade and are subject to low credit risk.
- Baa Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade and as such may possess certain speculative characteristics.
- Ba Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk.
- B Obligations rated B are considered speculative and are subject to high credit risk.
- Caa Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.
- Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.
- C Obligations rated C are the lowest rated class of bonds and are typically in default, with little prospect for recovery of principal or interest.
Don’t go overboard with ETNs, because even with good credit ratings, you could be rudely surprised. Remember that the rating agencies did not call the alarm about the mortgage crisis, which they certainly should have done.
How proactive or reactive they are is somewhat of a question — at least how much lead time they can provide you is a question. Lehman was downgraded this summer, but they only went from A1 to A2 in July, then 5 days ago they went under review (with direction of change stated as uncertain), then today, AFTER filing bankruptcy Lehman’s “bond implied” rating was reduced to B3 (ten credit levels lower). That was not helpful, because the bankruptcy has been filed.
Not too much overall damage can come from Lehman ETNs becoming worthless (or partially worthless), because the three ETNs they have issued (EOH, PPE and RAW) have attracted only about $14 million.
At the other end of the scale is Barclay’s which has gathered more than $4 billion for its 16 ETNs, the largest of which are DJP - commodities ($2.9 billion), INP - India ($0.6 billion) and COW - livestock ($0.3 billion).
Here are links to the ETN product sites, except for Goldman’s site which we have never been able to find:
It’s hard to replace the functional benefit of ETNs, so we don’t suggest avoiding them, but we do suggest investing with the strongest issuers and limiting total portfolio exposure to ETNs and to any one issuer.
We have identified 82 ETNs available in the US. The list with the name of the ETN, the symbol, the issuing bank, and the type of index is available upon request.
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This article has 6 comments:
- E F Nuttin
- 9 Comments
Sep 17 08:32 AM- puttster
- 22 Comments
Sep 17 10:43 AM- Richard Shaw
- 220 Comments
My Website
Sep 17 11:00 AMThe answer to your question is discussed in depth on my blog at
www.qvmgroup.com/inves...
- fran
- 144 Comments
Sep 18 01:22 PM- User 202460
- 2 Comments
Sep 18 10:05 PM- Richard Shaw
- 220 Comments
My Website
Sep 18 10:38 PMThank you for the kind words. Glad to be of some help.