With equity markets well above their March lows, and decent earnings reports announced by Goldman Sachs and JP Morgan this week, is the worst over for the financials sector? And how do the main European ETF issuers rank by credit spreads?
The chart shows the Counterparty Risk Index, as calculated by analysts at Credit Derivatives Research LLC. The index is a simple average of the five-year credit default swap spreads of the 14 banks in which financial sector counterparty risk is overwhelmingly concentrated.
The three clear spikes in the index show when concerns over bank default risk hit their peak, and tell the story of: the Bear Stearns near-failure and takeover (March 2008); the Lehman bankruptcy and near-failure of AIG (September 2008); and bankruptcy fears in March 2009 as equity markets fell to new lows.
Since March 2009, the CRI has halved, from a 300 basis point average CDS spread to the current level of just above 150. However, the index remains some way above its mid-2008 levels, while the 10 basis point spreads of early 2007 are a distant memory.
Can recent improvements be sustained? Tim Backshall, CDR’s chief strategist, notes that “financial earnings appear rosy at first glance, with Goldman’s blowout and JPM’s beat, but we temper our enthusiasm somewhat (and note the less ebullient performance of credit relative to stocks) as transparency into Level 2 and 3 assets in GS, and increasing non-performing loans at JPM provide some cause for concern.”
Time will tell, but this remains a key area to follow when assessing the durability of the recovery.
Meanwhile, what do markets say of the creditworthiness of the banks or financial institutions backing the major European ETF issuers? Although ETF investors do not carry the direct exposure to these institutions that an unsecured creditor would (since ETFs are funds, and investors’ assets are held separately from those of the bank concerned), the CDS rates are still relevant, since there may be some residual exposure to the parent bank through the swap in a swap-based ETF and, more broadly, credit spreads tell us something about the market’s view of the viability of the firms concerned.
Here, courtesy of credit information specialist CMA, are the five-year credit default spreads of the major European ETF issuers’ parent institutions. Excluded, because no CDS are quoted, are ETF Securities, ZKB and DekaBank/ETFlab.
|Bank||ETF Issuer||5Y CDS Spread (bp)|
|Deutsche Bank||db x-trackers||119|
|Bank of America ML||Source/(iShares)||190|
So, according to the credit markets, the most creditworthy parent banks of European ETF issuers are, in the following order, BNP Paribas, BBVA, Credit Suisse, Societe Generale, Credit Agricole and Deutsche Bank.
At the riskier end of the scale, we find the three founder members of the Source platform, Morgan Stanley, Bank of America Merrill Lynch and Goldman Sachs. While the CDS spreads of the first two approach 2% per annum, they have declined substantially over recent months; Morgan Stanley’s CDS level exceeded 10% per annum at one point in the immediate aftermath of the Lehman failure, for example. CDR’s Backshall believes that the credit spread differential between US and European banks will continue to narrow, by the way.
For iShares, I have referenced both Barclays, the current owner, and the two institutions that control BlackRock―Bank of America Merrill and PNC Financial―who will therefore become the majority owners of iShares’ parent BGI once the takeover completion date is reached in Q4. Interestingly, Bank of America Merrill Lynch, which owns 49.5% of BlackRock, will own more of iShares after the BGI deal is completed (39.6%) than it does of Source. Will Bank of America Merrill Lynch continue to have two major investments in the ETF industry, or will it give one up?
Again, these CDS rates cannot automatically be used for a direct ETF issuer-to-issuer comparison, since exposures to parent banks in swap-based ETFs may be marginal. But, other things being equal, an investor might prefer a bank with a lower CDS spread as his or her ETF issuer.
One other observation to make is that the recent decline in credit risk may make some investors more comfortable with holding ETFs that synthetic index replication (i.e. replication via swaps, rather than via holding the securities in the index concerned). Bank counterparty risk has frequently been cited as a reason for preferring replication-based to swap-based ETFs, even if many issuers have argued that these concerns are overblown.
If bank counterparty risk continues to decline, ETF investors will probably put parent banks’ credit spreads at the back of their minds when comparing funds by different issuers. If spreads start to increase again, though, this measure is likely to attract attention once more.