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CDS ETFs: Reaching New Highs (Lows?) in Complex Investments

Posted by Jack Duval

Jul 24, 2014 2:37:00 PM

This blog post continues our expert analysis of complex investments.

ETF issuer ProShares has filed an N1-A statement to release a series of "hedge strategies" ETFs which will invest in credit default swaps ("CDS") on various high yield and investment grade fixed income IIndices.[1]

The ETFs in the N1-A are:

  •   ProShares CDS North American HY Credit ETF
  •   ProShares CDS Short North American HY Credit ETF
  •   ProShares CDS North American IG Credit ETF
  •   ProShares CDS Short North American IG Credit ETF
  •   ProShares CDS European HY Credit ETF
  •   ProShares CDS Short European HY Credit ETF
  •   ProShares CDS European IG Credit ETF
  •   ProShares CDS Short European IG Credit ETF

Understanding Credit Default Swaps

A CDS is simply a contract where one party pays the other a fixed rate and receives back a variable rate. The variable rate received back is typically based upon how some underlying (refrence) security performs or the occurance of a certain event.

Most adults have a CDS, they just don't realize it.  It is life insurance.  You (the CDS buyer) pay the insurance carrier a fixed amount (your annual premiums) and receive back a variable amount (the face value of the policy) based upon a event (your death).  If you are alive, the variable payment is zero, if you are dead, the varialbe amount is the face value of the policy.

Below is a chart of a these cash flows for a CDS on a bond.

Chart 1.  Plain Vanilla Credit Default Swap




ProShares CDS North American HY Credit ETF (“NAHYC ETF”) Analysis

The Fund’s Investment Objective is “to provide long exposure to the credit of North American high yield debt issuers by selecting a broadly diversified, liquid credit derivative portfolio.”[2]  Like the people in Plato’s cave, owners of the NAHYC ETF will be three times removed from reality, in this case, the economic returns of North American high yield debt.

This thrice removal can be understood by realizing that investors in the NAHYC ETF will be purchasing an ETF that then purchases CDS based upon the economic returns of North American high yield bonds.

The Fund intends to primarily invest in centrally cleared, index-based CDS.

Selling credit protection is equivalent to being "long" credit.  Because the Fund seeks to provide long exposure to credit, it will generally be a net seller of credit protection with respect to North American high yield debt issuers."[3]

Simply put, this means you will be guaranteeing other people's investments in speculative high yield bonds.

You Can Lose More Than You Invest

"Because derivatives often require limited initial investment, the use of derivatives also may expose the Fund to losses in excess of those amounts initially invested."[4]

However, what is strange is that this disclosure seems to contradict what was published in Federal Register Release No. 34-72099 regarding the listing the ProShares CDS ETFs on the BATS Exchange.  To wit:

"The Funds will seek to obtain only non-leveraged long or short credit exposure, as applicable (i.e. exposure equivalent to Fund assets).”[6]

It's not clear how this can be if a Fund is 80 percent invested in CDS guaranteed full notional amounts of bonds far in excess of the swap payments it receives.

Positions Will Be Sold Out When They Move Against You

"With respect to the use of swap agreements, if the North American high yield CDS market has a dramatic intra day move that causes a material decline in the Fund's net assets, the terms of a swap agreement between the Fund and its counterparty may permit the counterpart to immediately close out the transaction with the fund...  This, in turn, may prevent the Fund from achieving its investment objective, even if the CDS market reverses all or a portion of its intraday move by the end of the day."[5]

In plain English, this means the swap counterparty can and will sell you out at the bottom on extremely volatile days.  This virtually guarantees losses if the market swings hard against you because they will sell you out at an intraday loss and you won't recover when and if the market rallies.  (This gives the CDS counterparties an unfair advantage, they can close out the position when it moves in their favor, but not vice versa).  It is similar to the constant leverage trap (which we discussed in detail in our Leveraged and Inverse ETF white paper), but worse.

Credit Events

"Upon the occurrence of a credit event (i.e. when you get stuck with a defaulted bond), the Fund will have an obligation to pay the full notional value of a defaulted reference entity less recovery value."[7]

You get put the defaulted bond and have to pay them the notional value of the bond less the recovery value (which will be haircut quite a bit).

If the fund is fully invested (by prospectus about 80 percent), and there is a significant credit event in one reference security, it will most likely be forced to buy back some of the other CDS written to raise cash to make good on the original defaulted bond.   This will almost certainly necessitate realizing losses on positions away from the initial credit event.

This chain of events could lead to a catastrophic decline in the value of the Fund.

Complexity Risk

Most frightening of all the risks inherent in CDS ETFs is ProShares' saying they don't know how the underlying CDS will perform.  And indeed, they say just that:

"Other risks of CDS include... the risk that the CDS utilized by the Fund perform in ways that are not expected."[8]

Warren Buffett has said that risk comes from not knowing what you are doing.  If you make investments without the knowledge of how they will perform, then you don’t know what you’re doing.

The ProShares CDS ETFs will allow individual investors to turn themselves into insurance companies like AIG.  Buyer beware: bailout not included.


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The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.


[1] ProShares Trust Form N1-A Registration Statement, May 31, 2013;  Available at;  Accessed June 25, 2014.

[2] Id. at 7.

[3] Id. at 9.

[4] Id. at 9.

[5] Id. at 9.

[6] SEC Release No. 34-72099; Self-Regulatory Organizations; BATS Exchange, Inc.; Order Granting Approval of a Proposed Rule Change to List and Trade Shares of Certain Funds of the ProShares Trust; May 6, 2014;  Available at; Accessed July 24, 2014; 3.

[7] See Supra note 1 at 9.

[8] Id. at 9.


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Topics: Complex Investments, Investment Complexity, Complex Investment Expert, ProShares

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