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ETF Specialist

ETN Credit Risk Rears Its Ugly Head

Lehman's bankruptcy sparks renewed caution with ETNs.

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 Lehman Brothers(LEH) bankruptcy this week had ramifications on the exchange-traded product universe besides its impact on financial exchange-traded funds. Most notably, the company's defaulting on its debt included defaults on the three exchange-traded notes that it sponsored: Opta Lehman Commodity Pure Beta ETN (RAW), Opta Lehman Commodity Pure Beta Agriculture ETN  (EOH), and Opta S&P Listed Private Equity ETN  (PPE). Judging by the lack of trading in these securities at the very end, we are assuming that most investors exited these funds before Lehman went under and the $14.5 million (as of Aug. 31) in these funds was mainly the original seed money from the firm and/or the specialist if there was a third party involved.

Even though it would appear that most investors escaped with minimal damage, the speed of the deterioration and the speed at which other institutions continue to stumble is worth noting. As a reminder, ETNs are essentially promissory notes from the sponsoring institution that carry credit risk, no matter the issuer. Two weeks ago, this may have seemed like an afterthought to most investors, but Lehman's stumble highlights the real risks involved in these instruments. ETNs still contain some advantages in terms of taxation (especially with commodities--at least until the IRS says otherwise) and are better for tracking indexes that are harder to physically replicate. Still, if faced with a choice between an ETF and an ETN that track the exact same indexes and have similar costs, we would recommend that investors choose the ETF because it doesn't carry the credit risk at all. 

The story doesn't end with Lehman. Currently  Morgan Stanley (MS) is suffering its own credit crunch. The investment house sponsors four currency ETNs in the Market Vectors family. In fact, on Wednesday, the Market Vectors Renminbi/USD ETN (CNY) traded with extreme volatility to its net asset value during the day before the arbitragers were able to bring it back in line. We chalk this up to investors fleeing the fund because of credit risk concerns. The other Morgan Stanley sponsored funds are Market Vectors Double Short Euro ETN (DRR), Market Vectors Rupee/USD ETN (INR), and Market Vectors Double Long Euro ETN (URR).

There are currently 93 ETNs issued with over $6 billion of assets under management. To put this in perspective, the overall ETF market is larger than $600 billion in assets. We have attached a list of all the ETN issues along with the sponsor bank and assets under management for you to review. For the most part, they are firms such as  Barclays (BCS),  Deutsche Bank (DB) and  UBS (UBS) that are considered in good credit standing. Again,  American International Group (AIG) was considered in good standing until about a week and a half ago, so keep the credit risk in mind when choosing your investments.

Lehman's Index Business
As a side note, Lehman also had a prominent index business and its bond indexes were pretty much the industry standard. Barclays' acquisition of Lehman's capital markets group included the index businesses. According to representatives from iShares and iPath (Barclay's ETF and ETN groups) the plan is to keep the indexes running under the Lehman moniker. Barclays has a very respectable bond trading business in its own right, so we aren't expecting a material drop-off in respect. That said, it could open the door for some other indexes and/or sponsors to move in. We would be surprised if the indexes keep the Lehman name for much longer. It is hard to imagine why Barclays wouldn't utilize the free marketing and branding and dump the Lehman name, which is now, like it or not, tainted with a bankruptcy.

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Scott Burns does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.