Last Updated: 19 March 2023
The strains in the credit markets have erupted into an outright crisis.
Here are some figures showing the extent of the problems
- The iTraxx crossover index broke through 800 basis points yesterday and 900 today. At 1000 b.p. this would imply that a majority of index constituents are going to default.
- The em10 emerging market debt index has traded through 1000 basis points this week, almost doubling since a week ago. Rumours of default abound. The CDS premia on the worst-affected countries – Argentina, Ukraine, Pakistan, Venezuela – are all at well over 10%, some over 20%, per annum.
- The bank counterparty risk index has subsided over recent weeks, since the latest bailouts effectively gave government backstops to a large part of the banking sector in Europe and the US. But overall credit market strains have increased, as the default risk on non-financials has shot up. An image of Paulson, Bernanke, Brown and Darling comes to mind – as little boys running out of fingers to stick in the dyke.
How have ETFs operating within the general credit sector been performing? There are several funds that reflect the crisis directly:
The iShares JP Morgan Emerging Market Debt fund, which has New York and Dublin listings (NYSE: EMB) has fallen from near par at end-August to under 70 today, a decline of 30% in under two months.
The three iShares corporate bond ETFs – in dollars, Euros, and sterling – have fallen by 25.9%, 8.4%, and 18.2% from their peaks earlier this year, respectively. The differences in the respective returns reflect the fact that the corporate issues selected are chosen on the basis of their liquidity, and may have quite different sectoral exposures or maturities.
The most volatile of Deutsche Bank’s credit ETFs, the db x-trackers iTraxx Crossover 5 year total return ETF, has fallen by 13.3% from its peak in May. Interestingly, the short (inverse) version of the same fund has risen by 17.8% over the same period. It’s not immediately clear why there has been such a divergence. The other two DB credit ETFs – the iTraxx HiVol and iTraxx Europe – have not shown such a clear directional trend during the year. It may well be that there have been significant substitutions in the relevant indices, which roll into new versions each six months.
This gives a broad-brush picture of what has been happening. With so many things happening in the credit markets it’s difficult enough to keep track of price movements. But in my view there are still quite a lot of things missing from the credit investor’s ETF toolbox. The equity investor is spoiled by comparison. So here’s an off-the-top-of-my-head wishlist of what might be good to see:
- Credit ETFs that are not based on credit ratings. The current credit ratings system has been useless in helping to predict the crisis – arguably, it has caused it (!) – and until a viable new system is put in place, there must be better ways of building indices. At the moment most are constructed according to ratings categories.
- Second, and this follows from the first point, investors need ways to hedge regional, country, or sectoral exposure – at the moment there’s no easy way to hedge against Russian default risk, or the default risk of automakers, to give two examples. With default risks rising at various rates even within the Eurozone, does it make sense to have ETFs that lump together all European government bond issuers? Shouldn’t we split out the individual government names?
- More thought needs to go into index weighting methodology. Capitalisation-weighting never made sense for bond indices, as the heaviest issuers, who are often the least creditworthy, get the biggest weighting. A great deal of innovative thinking has gone into equity market index construction, with many alternatives to cap-weighting now available. Bond investors deserve the same.
These are longer-term objectives, and I’d be interested to hear readers’ thoughts. In the meantime, the credit markets are telling us that we should brace ourselves for a wave of defaults, so perhaps we should see if and how we get through that first!