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Just Walk Away From Credit-Default Swap ETFs

It’s no secret that we here at InvestorPlace love exchange-traded funds (ETFs). These baskets of stocks, bonds and other assets have leveled the playing field for regular retail investors.

Corporate BondsETFs allow us to get broad core positions on the cheap, make calculated bets on various sectors and even get access to some sophisticated asset classes, such as commodity futures or hedge fund-styled strategies.

But that doesn’t mean we need an ETF for everything.

In fact, a pair of recent fund launches from ProShares provide great examples of products that can be more harmful than helpful to average Joes.

You Can Be the Next John Paulson!

Just when you thought that every class was covered by an ETF, ProShares comes out with a pair of funds that covers something new … and potentially diabolical.

These ETFs give us the ability to buy and sell credit-default swaps (CDSes).

At its core, a CDS acts very much like an insurance policy. An investor buys protection to hedge the risk of default on a bond or other debt instrument. So if you think XYZ Inc. will default or has a chance to default on its bonds, you purchase a swap that will pay you in the event that it does.

In short, if you’re buying a potentially risky IOU, CDSes come in handy.

However, the similarities to an insurance policy end there.

The kicker is that investors in CDSes don’t have to hold or have any interest in XYZ’s bonds. The credit-default swap can therefore be used to speculate on various debts. And they do. More than $8 billion of CDS trade hands every day. That’s more liquidity than the high-yield bond market itself.

Secondly, swaps can be written by anyone — even those firms from outside a regulated entity. And sellers are not required to keep any sort of reserves to cover any CDS they’ve written.

So a CDS really is insurance that comes with a bit of risk themselves — it can be lucrative, but it can also be extremely dangerous.

If you remember, credit-default swaps were a part the alphabet soup of various securities and derivatives that basically helped spur on the credit crisis and late-aughts market crash, and what helped force insurer AIG (AIG) into needing a bailout from the U.S. government during the recession.

However, several hedge fund managers like John Paulson made billions on swaps tied to the housing market and subprime mortgage loans — essentially huge bets against these markets — which is why they still have some allure, and which is why ProShares is bringing a couple new products to market.

OK, These ETFs Won’t Actually Make You the Next John Paulson

Alternative ETF issuer ProShares is now offering ETFs that bet on credit-default swaps: the ProShares CDS Long North American High Yield Credit ETF (TYTE) and the ProShares CDS Short North American High Yield Credit ETF (WYDE). Moreover, ProShares has six more CDS funds in registration that will bet on other aspects of the bond market.

Focusing on TYTE and WYDE, though: These ETFs make it easy for anyone to bet on the direction of the credit markets — in this case, U.S. junk bonds.

Right off the bat, the names are a tad bit confusing. TYTE, which is long credit, is actually short credit-default swaps. WYDE is the opposite — so if you think the markets will implode, you’d actually buy WYDE, which is long credit-default swaps.

The other issue is just what these two ETFs actually own.

The funds track highly liquid swaps on the Markit CDX North American High Yield Index. The ETFs, however, don’t actually own credit-default swaps of a pile of junk bond issuers. The CDX index is actually a bond-like security itself made up of 100 issuers of equal weights. The CDX index pays a coupon just like a bond, and in the event of a default or credit event from one of its issuers, the index closes and settled via auctions. The CDX index will then re-roll and re-create its index again. If no default or credit event happens after six months, the CDX index will then re-create its index of new CDSes.

If that sounds confusing, don’t worry — it is.

The credit default swaps market is really just a way for sophisticated investors to hedge away their risk, which is great. But these ETFs are open to everyone — including regular retail investors who probably shouldn’t walk into this particular asset class — which means caution is the word du jour.

It’s very tempting to see the headlines about outflows from junk bond ETFs — like the iShares iBoxx $ High Yield Corporate Bond (HYG) — and think, “I need insurance.” It’s also very tempting to see appealing yields, such as TYTE’s 3.45%. Really, the timing of the launches couldn’t be any better for ProShares.

But these funds aren’t right for everyone. They’re not even right for most.

And in fact, they might not even be right for sophisticated, deep-pocketed investors. After all, if you’re seriously worried about hedging your credit risk because you’re an institutional investor or pension fund, you can just buy credit-default swaps on your own. Remember: More CDSes trade than actual junk bonds. There’s no need for an ETF.

And if you’re an individual guy just saving for retirement, odds are you don’t need to worry about “hedging” your junk bond default risk.

Just skip TYTE and WYDE. Leave the credit-default swaps to John Paulson.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2014/08/credit-default-swaps-cds-tyte-wyde/.

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