I actually liked the way you laid out the arguments for and against ETNs in your recent blog. On the plus side, ETNs offer zero tracking error. On the negative side, they come with credit risk.
But while I agree that investors should assign some cost to an ETN’s credit risk, I think you seriously overstate the size of that cost by proxying it off of credit default swaps. The risks that CDS contracts protect against and the risk associated with ETNs are vastly different.
When you buy a CDS contract, you are covering yourself against a bond’s default for five years. When you buy an ETN, your credit exposure is limited to a single day, because you can always redeem the ETN back to the issuer.
You acknowledge this in your blog, but then dismiss its value, noting:
“[S]ceptics point out [that] the option is worth somewhat less for being granted by the same entity as the one issuing the bond, since it will be of limited or no use if the issuer gets into trouble.”
But remember: ETN aren’t like most bonds. The credit risk is entirely binary. An ETN is either worth 100% of its net asset value, or it is worth zero. That is a critical difference.
Bonds vs. ETNs
To illustrate, let’s suppose that you went out and bought two things in your brokerage account: a 10-year bond of Barclays debt and an iPath ETN underwritten by Barclays. The next morning, you woke up and read in the paper that Barclays had cooked its books and actually had half the cash it previously claimed.
What would happen?
The bond would certainly fall in value. By the market’s assessment, the risk that Barclays will default on its debt will have increased, so the bond’s price must drop.
But the ETN should continue to trade normally at net asset value. While the risk of default may have risen by 10 or 20 percent, it’s still relatively small. In the meantime, investors can still redeem their ETNs at full value, which means the notes will still trade at full value. In fact, Lehman processed redemptions on its ETNs right up to its eventual bankruptcy.
For investors who are paying attention, the risk that a bank like Barclays will go bankrupt overnight without you noticing is very small. It’s not zero, and CDS rates are absolutely the right mechanism for comparing the relative risk of competing banks issuing ETNs. But it’s not fair to assign the full cost of a CDS contract to an ETN’s expense ratio. That overstates the risk and the costs substantially.
