Having revolutionized investing for both ordinary retail investors and institutions, and increasingly crowding out traditional asset managers, ETFs have set their sights on yet another market to disrupt and dominate: the trillion-dollar market in credit derivatives.
Ten years after the financial crisis, a London-based provider of passive products is testing whether the trading strategy of selling default protection has appeal beyond a rare group of institutional debt investors according to Bloomberg. The UK company, Tabula Investment Management, listed an exchange-traded fund on Sept. 7 that tracks a gauge of credit default swaps on European corporate bonds, joining only a handful of ETFs that offer similar exposure. And for the privilege of pretending one is the reincarnation of AIG Financial Products, Tabula will charge an annual fee of 0.5%.
Allowing ordinary investors to join sophisticated hedge funds while bypassing the need for a burdensome ISDA agreement, the Tabula European Performance Credit UCITS ETF (ticker TCEP) works very much how a regular CDS does: it provides a long position in the region’s credit markets by selling protection against default on a group of investment-grade and high-yield companies.
The fund earns a coupon with this strategy, though in the event of a default or other credit event, it could be forced to pay out — causing losses. The prospect of bringing speculative credit trading to more mainstream investors — even the Mom and Pop crowd — would displease Pope Francis, who rebuked the market in May as a “ticking time bomb.”
Sarcastic religious commentary aside, the fact that banks are opening up CDS to retail means that there is increasingly little institutional interest to sell CDS (i.e. buy bonds), and as a result the market must be opened to retail investors, who have been eagerly devouring the stocks that institutional investors have been selling to them in ever larger amount in recent years.
The CDS ETF comes months after European regulators warned in April that investors who have presided over a “deterioration’’ in the overall quality of European corporate debt could be caught off-guard by monetary tightening.
Then there is the whole “derivative of a derivative” issue, although we are now so deep into the current asset bubble, that it is not even worth discussing that the modern equivalent of CDOs squared will not have a happy ending.
What is the spin to get mom and pop investor hooked on doing what AIG do infamously did a decade ago with devastating results? In other words, why invest in an index of swaps rather than buy a plain vanilla ETF tracking cash bonds? Simple: the former strips out interest-rate risk from the equation, according to a release from Tabula.
“Specialist credit managers can isolate and manage credit risk using credit default swap indices,’” said Michael John Lytle, chief executive officer of Tabula. “This is a liquid and efficient market, but it isn’t accessible to all asset managers.’’
On the other hand, it was not immediately clear why retail investors would be concerned about isolating credit risk, and furthermore, why they would then turn around and buy an index of swaps which dilutes the impact of the single-name focus.
Meanwhile, institutions have also recently taken to CDS indexes whose volumes have surged as volumes in the cash bond and single name CDS markets have tumbled in recent years, and as money managers seek more liquid alternatives. As Bloomberg notes, institutional respondents to a recent Greenwich Associates survey said they preferred index swaps to single-name CDS. Amid an uptick in volatility, U.S. credit derivatives trading volume jumped 65 percent year-on-year in the first half of 2018, according to JPMorgan.
Until recently, aside for a handful of passive products, the only way to gain exposure to CDS indexes was via derivatives and structured notes, instruments which allow investors to take short positions as well.
To be sure, it is unclear if the plan will work: while a handful of XTrackers ETFs that track indexes of European CDS have managed to gather hundreds of millions of euros in assets, others have been less successful.
In the U.S., ProShares closed one of a pair of long/short products tied to North American CDS indexes, while the remaining fund, the ProShares CDS Short North American HY Credit ETF, holds less than $5 million in assets.
But what is most subversive about the Tabula ETF is that it will put retail investors on the other said of the increasingly popular “fallen angel” trade which many institutional managers such as Oaktree and Horseman Global believe will be the next big short: nearly half of its long exposure to BBB names that some hedge funds have targeted with short positions.
One wonders if “some” of the funds who have been seeking counterparties to take the long side of the “fallen angel” trade didn’t call Tabula and, in a repeat of what John Paulson did with Goldman when the two schemed to structure CDOs in a way that would maximize prodits, urged the company to allow retail investors to be the bagholder for what may soon be the trade of the decade.
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