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I don’t know about you, but here in Texas I can barely drive a mile without passing a JPMorgan Chase (JPM) branch. They’re even inside the grocery stores.
Simply being everywhere doesn’t make a bank safe, of course. As we learned last week, traders in London just cost JPMorgan $2 BILLION and possibly more! Fitch Ratings downgraded its credit rating one notch to A-plus, and it looks like Moody’s may cut the bank, too.
Weiss Ratings, ahead of the curve as usual, cut JPMorgan Chase to “D” on September 30, 2010. And on October 22, 2010, they issued a special news release advising subscribers that among U.S. banks, JPMorgan was carrying the largest volume of mortgages in foreclosure or foreclosed. In addition, it had $43.4 billion in mortgages past due.
If you’ve invested in one of the three exchange-traded notes issued by JPMorgan, the losses and downgrades may concern you. Congratulate yourself. You’ve already shown more awareness of risk than this bank’s top executives … but that’s another subject.
Today I’ll explain the impact of credit downgrades on an ETN issuer and how investors should react.
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| We lost $2 billion. Oh well. |
ETNs: A Quick Review
As a Money and Markets reader you are probably familiar with ETFs: Exchange-traded FUNDS. Exchange-traded NOTES look similar on the outside, but are really a different species.
Here’s how I explained it last year in “Does Another Lehman Have Your Money?” You may want to go back and read that column again.
- When you buy an ETF, you receive partial ownership of an independently organized entity — a “fund.” By pooling your money, you and the other owners do something together that would be hard to accomplish individually.
- When you buy an ETN, you’ve loaned your cash to the issuing bank. All you “own” is an unsecured liability. That’s banker talk for an “IOU.”
Now if someone owes you money, and you observe them losing money with stupid decisions, you might not lend them anymore. Or if you do, you might demand a higher interest rate. Credit ratings help investors make these judgments.
A credit downgrade normally leads to lower market prices for an issuer’s existing debt, too. But ETNs, even though they are debt, don’t behave like other bonds.
How ETNs Are Different
ETNs can create and redeem new shares at any time, just like ETFs, at the present net asset value (NAV). The NAV, in turn, is based on whatever underlying index an ETN is supposed to track. Issuer credit risk isn’t part of the NAV calculation.
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| NAV follows the index, not the issuer. |
What does this mean? Here’s the bottom line: Unless JPMorgan goes into default (possible but still very unlikely), credit downgrades have little or no impact on ETNs issued by the bank.
Please note, I am NOT saying ETNs are risk-free. Far from it. They go up and down with their index, and they have default credit risk, too. My point is that the credit risk manifests itself in a different way.
Individual bonds issued by JPMorgan or any other bank can trade higher or lower based on the credit rating. ETNs issued by JPMorgan or any other bank treat default as an “all-or-nothing” risk.
Unlike traditional bonds that can’t be returned to the issuer until they mature, the redemption feature of ETNs means they can be returned to the issuer and any associated risk is eliminated in the process. So while the ETNs may have a stated maturity of 10 or 20 years, the redemption feature effectively shortens this period to days.
Make no mistake: ETNs will almost certainly lose value in a default scenario. That’s what happened to several issued by Lehman Brothers when that firm went bankrupt in 2008. Short of this extreme, however, other factors are far more important to ETN prices.
ETNs from JPMorgan
JPMorgan Chase sponsors three ETNs:
- JPMorgan Alerian MLP Index ETN (AMJ)
- JPMorgan Double Short U.S. 10-Year Treasury Futures ETN (DSXJ)
- JPMorgan Double Short U.S. Long Bond Treasury Futures ETN (DSTJ)
The first one may sound familiar to you. I’ve mentioned AMJ before as a way to gain income from master limited partnerships. It’s still worth a look if you want to participate in that niche.
DSXJ and DSTJ are, ironically, designed to “hedge” the risk of rising long-term interest rates. As much as their issuing bank loves to hedge, both ETNs are struggling to attract assets as well as trading volume.
An ETN can be a great investment in the right scenario. The issuing bank’s stability is one factor to consider. But it’s only one factor, and not necessarily the most important one. As always, you should look at the big picture.
Best wishes,
Ron
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