The ETF world saw a big step forward on the innovation front last week, as ProShares debuted two ETFs that utilize credit default swaps for their investment strategy: the CDS North American HY Credit ETF (TYTE) and the CDS Short North American HY Credit ETF (WYDE). These actively managed funds are the first of their kind and are arguably one of the most original products to hit the ETF shelves in quite a long time. Credit default swaps are not meant for your average investor, as they can be quite complex, making this launch all the more intriguing [for more ETF news and analysis subscribe to our free ETF Daily Roundup].
What are Credit Default Swaps?
Let’s start with the basics. A credit default swap (CDS) is a kind of derivative that was introduced in 1997 (and came under heavy fire during the 2008 financial crisis). These are contracts between two parties, which are essentially an insurance contract against a bond. The seller of the contract will take on the credit risk in exchange for a periodic fee and is only forced to pay out if a negative credit event occurs. Buyers can use these swaps to protect themselves against any kind of negative event for some of the bonds that they hold.
In the event of a negative credit event, the seller of the contract must provide the buyer with the principal and any interest payments the bond would have paid. If no credit even occurs, the seller collects the periodic fees and does not make any payments out to the buyer; working almost in an almost identical manner to insurance [see also Using ETFs As “Portfolio Insurance”].
These swaps can be used as a hedge to protect one’s holdings, or as speculative instruments concerning the credit quality of the bonds that the CDS references.
First things first, these two ETFs are designed for sophisticated investors; they should not be used by your average retail investor or anyone who does not fully appreciate the complexities of CDS derivatives. Also note that both funds are designed for short term holding and trading and would never be a part of a long-term or retirement strategy.
TYTE grants long exposure to the high yield bond market in North America and will distribute quarterly dividends in an effort to provide some income on top of its interest rate and credit risk hedges. TYTE will profit from rising bond prices.
WYDE utilizes the same exposure, but instead applies a -100% leverage; essentially it is the inverse version of TYTE. By that virtue, WYDE is set to perform better when bond prices are falling, something that many fear will happen in the coming months and years [see also Ten ETFs To Own If (When) The Fed Raises Rates]. This has been well evidenced by the fact that WYDE has had higher trading volumes since both funds debuted on 8/5/2014.
Both funds charge 50 basis points for investment, a relatively cheap fee structure given the active management of the fund.
The Bottom Line
TYTE and WYDE have certainly pushed the envelope on ETF innovation, and ProShares has plans to release two more funds that utilize the same strategy for European bonds. Be sure to take a thorough look under the hood of these complex products before you make any kind of allocation.
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Disclosure: No positions at time of writing.