First Credit Default Swap ETFs Hit the Market - ETF News And Commentary

The recent market gyrations resulting from worries over the cease in cheap-dollar flows by the year end, possibility of hike in interest rates sooner-than-expected and stock market volatility, have left investors jittery about the safety of their portfolios and brought rate worries back on the table. 

Market participants' are busy predicting the exact timing of the interest rate hike.  In fact, investors and fund issuers have started preparing for a potential hike in interest rates next year.  While bargaining for such moves, high-yield bond comes across as an interesting investing option.

Notably, bond investments hardly saw gains in 2013 thanks to taper concerns. However, across the spectrum, the high-yield bond space has been less ruffled, with most losing marginally in the YTD frame (read:

).

However, high-yield bonds also have their share of problems. These bonds normally carry lesser investment grades and high default risks. Amid such a situation, what could be a better option than having an exposure to the high yield bond market (to fight rising rate risks) but not being exposed to credit risks?

Initially, many investors might wonder if this is at all possible. For them, we would like to mention that minimization of default risk is possible through credit default swaps. The U.S. ETF industry was so far void of such a product.

However, on August 8, 2014, ProShares launched two products on this theme, namely

(TYTE) and

(WYDE) on the BATS exchange.  

defines credit default swap (CDS) as insurance against non-payment. A CDS buyer might be speculating that the third party would indeed default. This is actually a credit derivative contract, where the buyer of the swap remunerates the seller of the swap till the maturity date of a contract. As a service, the seller will fill the bill of a third party debt if the party defaults on the loan (read:

).

As per a

, the high yield CDS market is extremely liquid in nature as evident from around $8 billion in average daily trading volume. The market is in fact more liquid than the high yield bond market itself. The high yield CDS market has also been less volatile.

Both funds are actively managed and offer exposure to a portfolio of credit derivatives, the underlying entities of which are North American junk bond issuers. WYDE and TYTE provide long and short exposure, respectively.

Put it simply, the funds invest in index-based CDS which is correlated to the North American high yield credit market. While TYTE takes a bullish stance on the credit component of the North American High yield bond market and bearish position on CDS, WYDE does the opposite. Each fund charges 50 bps in net expense ratio though gross expense ratio is higher at 1.04%.

As of August 5, 2014, holdings for swaps with maturity date 6/20/2019 had 83% exposure with the remaining going to swaps with maturity date 12/20/2018.

Investors looking for a fixed-income play in high-yield segments could consider these products. These have been designed to counter interest rate risks as well as default risks in bond investing. WYDE should be tapped by investors to evade the credit risk attached to high yield bonds while TYTE might serve those having rather strong nerves and looking for high yield credit exposure.

In today's environment, default factors seem to be taken care of given the two major debt defaults noticed in the near past. A few days back, Argentina defaulted on its loans. Espirito Santo International, the largest shareholder in Banco Espirito Santo (“BES”) – one of the biggest banks in Portugal – also allegedly defaulted on a debt payment and was accused of accounting discrepancies mid July (read:

).

The U.S. economy also faced a political tussle on debt-ceiling issue last November. On the other hand, corporate bond issuances have been robust. So, protection against credit quality seems warranted for investors with weak nerves. Along with the U.S., the products will target the corporate debt of

. Notably, the region is still not out of the woods as of yet.

In one sense, the products should not face any competition as the duo was the first to hit the U.S. market. A press release noted that an array of ETFs with similar types of exposure has been on hand in Europe for long, but the products were new in the U.S. market.

The market might see a flurry of CDS ETF launches in the months to come and those products might be positioned as direct peers of TYTE and WYDE. But, then again, the newly launched ETFs will score on their first mover advantage and presumably will keep tasting success, if the concept of CDS becomes popular among ETF investors (read:

).

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