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Survival of the (Un)Fittest

The iPath DJ-UBS Commodity Index exchange-traded note's success is puzzling when there is a superior ETN option.

Samuel Lee, 03/30/2012

Besides being uncollateralized loans to investment banks, many exchange-traded notes are larded with hidden fees and other harmful terms. A classic example is iPath DJ-UBS Commodity Index ETN DJP, which uses a devilish fee calculation to quietly shift more risk to investors at the worst times possible. However, the actions of some shouldn't necessarily condemn all. Despite many similarities with DJP, ELEMENTS Rogers International Commodity ETN RJI, a broad commodity index tracker, is a far better deal. Strangely, DJP has more than $2.4 billion in assets while RJI has less than $800 million, a clear instance of the inferior triumphing over the superior.

It's all really unfair. Even though it doesn't seem like it at first glance, RJI handily beats DJP on three major criteria: credit risk, fees, and diversification. Let's look at each in turn.

Credit Risk
All ETNs possess credit risk, but some have a lot more than others. According to Moody's, DJP's backer Barclays PLC is a solid Aa3 credit, only three notches below the coveted Aaa. Moody's thinks RJI's backer, the Swedish Export Credit Corporation, or SEK, is an Aa1 credit, only a notch below Aaa. The rating agency describes Aa ratings as signaling "high quality" and "very low credit risk." One might be tempted to conclude there's not much of a difference in credit risk between DJP and RJI.

In reality, credit ratings issued by the major agencies--Moody's, Standard & Poor's, and Fitch--are sticky, lagging indicators. The ratings are the product of a hopelessly conflicted business model, where issuers pay the raters and are able to shop around for the best ratings. (Morningstar issues its own corporate credit ratings for free.)

The credit default swap market is a better source of credit-risk information. A CDS is basically an insurance contract that pays off when a loan defaults. CDS prices can be interpreted as the market's judgment on the probability of default. Many sophisticated institutions trade in the market, staking billions of dollars on the outcomes. It's a no-brainer that CDS spreads should be the primary input in estimating an issuer's credit risk.

As of this writing, five-year CDS spreads for Barclays PLC debt trade at levels implying Barclays is really a Baa-rated debt--that is, according to Moody's rating scale, debt with "speculative" characteristics. No surprise here. Barclays is close to the epicenter of the slow-burning eurozone debt crisis.

SEK doesn't have a liquid CDS market for its debt, if at all. However, SEK is fully owned and backstopped by the Swedish government, which itself has CDS spreads narrower than all but the governments of Norway and the United States. (Sweden has its own currency and a solid balance sheet, so it's better insulated from the debt crisis than many other European sovereigns.) SEK's Aa1 credit rating is likely close to reality.

Bottom line: RJI's credit risk is likely much lower than DJP's, regardless of what the credit rating agencies say.

Samuel Lee is an ETF Analyst with Morningstar.

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