Reviewing credit risk in the wake of another financial crisis.
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By Bradley Kay | 01-22-09 | 11:00 AM | Email Article

Just last week, I titled an article "ETN Risk Rears Its Ugly Head." If only I had known that I would want to reuse that title so soon. Bank stocks are plummeting once again, but this time three particular banks concern our ETF team:  Deutsche Bank ,  Barclays , and  State Street . My colleague Paul Justice already addressed the concerns of investors in SPDRs and iShares ETFs in his article on Tuesday, but I wish to expand upon the implications of the recent market movements for investors in ETNs such as the iPath series or the PowerShares commodities ETNs, backed by Barclays and Deutsche Bank, respectively.

Bradley Kay is Director of the European ETF Research team.

For those who have not read Paul's article, it says, in short, that ETF shareholders do not need to worry even if the bank managing their funds goes under. Exchange-traded funds, like traditional open-end mutual funds, are legally set up as trusts separate from the bank corporations. The assets within these trusts cannot be touched during bankruptcy proceedings, as they belong wholly to the shareholders of the fund. We also remain unconcerned that bankruptcy might disrupt the ETF management, hurting the funds' index tracking. Not only do companies generally remain operating through bankruptcy proceedings in order to unwind their businesses in an orderly fashion, but the asset-management side of these banks (Barclays Global Investors and State Street Global Advisors) would be among the most sought-after acquisitions in any post-bankruptcy asset sales. In the worst-case scenario, the parent company may change, but the SPDRs and iShares funds are simply too valuable for potential owners to risk capital flight through poor management.

Investors in ETNs are not so fortunate. These exchange-traded products track a variety of otherwise-inaccessible investments and provide handy tax benefits for any higher-turnover strategies. These benefits pushed ETNs into a dominant position among commodities funds, where the ETF alternatives tend to be set up as partnerships and require fairly complicated tax accounting. However, these products do not have a claim on a separate trust of assets but instead are debt instruments issued by the backing bank and redeemable on a daily or weekly basis for the value of a promised index return minus expenses. Those seeking a more in-depth explanation of the ETN structure should read this recent article by John Gabriel. In summary, ETNs eliminate tracking error on the underlying instrument and simplify taxes, but they expose shareholders to the credit risk of the backing bank. If the bank declares bankruptcy, shareholders in an ETN have to queue up along with all the other debtholders to try to claim their share of the company's assets.

Normally this credit risk appears negligible, especially given the liquidity and frequent redemptions allowed with ETN shares. However, when shares in Deutsche Bank and Barclays have fallen around 80% in the past year and the bankruptcy of Lehman Brothers remains fresh in every investor's mind, bank credit risk seems very worthy of consideration. Even if we take for granted that shareholders can pull all their assets out of an ETN before the bank collapses entirely, there still remains the disruption of having to liquidate an investment position in an emergency situation, with possible adverse tax consequences or difficulty finding a new position to fill the same place in an asset allocation. This concern does not necessarily justify selling out of any ETN stakes right now, but it certainly should push investors to consider alternatives in case their fund's backing bank should grow wobblier.

Investors in the Deutsche-Bank-backed series of PowerShares ETNs are particularly lucky when looking for ETF alternatives. Those content with a single-long position in a given Deutsche Bank commodity index can find an exact equivalent among the PowerShares ETF lineup. For those who used PowerShares ETNs to get leveraged or short commodity exposure, ProShares just issued a lineup of double-long and double-short commodities ETFs based on the DJ-AIG broad index as well as crude oil, gold, and silver funds. Of course, we must list our normal caveats for leveraged and short ETFs: These funds are extremely tax-inefficient because of the short-term instruments they use, and their compounded returns tend to drastically underperform the benchmark over long periods due to volatility drag and the effects of constant leverage. The former provides reason to stay in the ETN so long as Deutsche Bank appears fairly solvent, while the latter warning applies to all leveraged and short funds.

Those invested in iPath ETNs may have a harder time finding precise substitutes, but appropriately similar ETFs do exist for most funds. The single-sector or single-commodity ETNs mostly have close matches in the PowerShares ETF lineup, but those looking for a broad-based replacement for the  iPath Dow Jones-AIG Commodity Index Total Return  will have a harder time. Neither  iShares S&P GSCI Commodity-Indexed Trust  nor  PowerShares DB Commodity Index  hold as broad or balanced of a commodities basket, though at least the iShares trust tries to match an established passive index. Investors in the CBOE S&P 500 BuyWrite strategy could instead use the PowerShares S&P 500 BuyWrite ETF , which tracks the same index. Anyone looking to profit from the synthetic carry-trade strategy of iPath Optimized Currency Carry ETN  might want to look at  PowerShares DB G10 Currency Harvest  as an ETF alternative. Finally, those investing in India through the iPath MSCI India ETN  could instead look at PowerShares India  or the value-tilted WisdomTree India Earnings . Once again, investors face a large trade-off between the superior tax benefits and tracking of the ETN versus the secure claim on the portfolio assets in the ETF, so we cannot make a clear-cut case for either investment structure in these more esoteric asset classes at the moment.

For now, ETN investors may also find some solace in the knowledge that the situation is not as dire as the precipitous equity drops of Jan. 20 made it seem. Barclays has already issued a statement that its fourth-quarter results (due Feb. 17) will exceed analyst expectations. Even on the same day that the ADR for Barclays common stock fell 43%, its debtholders barely blinked. Credit default swaps for Barclays Bank, which measure the market's best guess of the company entering bankruptcy, only moved up 7 basis points to a default probability of 2% over the next five years. This remains a fairly distressed bank, but its risk of default does not seem to have substantially risen in the past week. Most likely, this is because the market expects continued government bailouts that dilute common and perhaps preferred shareholders while leaving bank debt more secure. So long as the U.S. and U.K. governments wish to avoid another complete collapse like that caused by the Lehman Brothers bankruptcy, ETN shareholders can rest a little easier. Just keep an eye on the news, and always have a potential replacement in mind.

Disclosure: Morningstar licenses its indexes to certain exchange-traded product providers, including Barclays Global Investors (BGI), First Trust, Claymore, and Merrill Lynch, for use in exchange-traded products. These exchange-traded products are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in the exchange-traded products that are based on Morningstar indexes.

  

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