The decline in the commodities space is stirring speculation that many heavily indebted commodity producers will go into default. Exchange traded fund investors, though, may hedge default risks with a credit default swaps strategy.
ETF investors can hedge against the rising credit risk through a credit default swaps-related ETF, the ProShares CDS North American HY Credit ETF (BATS: TYTE).
A credit default swap is essentially insurance or protection against non-payment of a debt obligation or default. A CDS is a type of swap designed to transfer the credit exposure of a fixed-income security between two parties. The buyer of the swap makes payments to the swap’s seller up until the maturity date of the contract, similar to a regular insurance payment. In return, the swap seller agrees to pay the buyer the security’s premium as well as interest payments in the event that the debt issuer defaults.
In an environment where credit default risk is rising, a CDS grows more desirable and the more the premium is worth.
Currently, with commodity prices falling, more debt traders are growing wary of default risk in the energy and materials sectors. TYTE’s sector exposure includes 7.5% energy and 10.2% materials, along with consumer discretionary 26.6%, financials 14.9%, communications 13.9%, tech 8.0%, health care 5.7%, consumer staples 5.6%, utilities 4.9% and industrials 2.9%.
As crude oil prices are falling toward seven-year lows after the Organization of Petroleum Exporting Countries decided to keep pumps flowing at near-record levels, many energy company bonds have started trading at levels that suggests greater defaults, the Wall Street Journal reports.
Nymex crude futures falling below $40 again “was sort of a psychological barrier,” Jody Lurie, corporate credit analyst at Janney Montgomery Scott, told the WSJ. “It’s causing a certain element of panic, particularly as you see more and more companies indicating that they’re operating in a challenging environment.”