BDCZ - BDCZ: This BDC ETN Is Not Worth The Risks

2023-04-19 15:05:43 ET

Summary

• The ETRACS MVIS Business Development Companies Index ETN is an exchange-traded note from UBS Group.
• The ETN aims to track the return profile of a BDC index called the MVIS US Business Development Companies Index.
• As an exchange-traded note, the vehicle runs default risk, call risk, market risk and redemption risk.
• The fund lags from a performance standpoint when compared to the VanEck BDC Income ETF, a vanilla fund in the space.

Thesis

The UBS ETRACS Wells Fargo® Business Development Company Index ETN (BDCZ) is an exchange-traded note ("ETN") from UBS Group AG (UBS). Given the Credit Suisse Group AG (CS) turmoil, a retail investor should be fully aware by now that an ETN actually represents a bond issuance rather than a counterparty risk-free instrument.

BDCZ is a medium term note issued by UBS AG:

UBS Switzerland AG is not a co-obligor of the ETNs and has no liability with respect to the ETNs. If UBS AG fails to perform and observe every covenant of the indenture to be performed or observed by UBS AG with respect to the ETNs, holders of the ETNs will have recourse only against UBS AG, and not against UBS Switzerland AG.

In its risk disclosures, the bank is fairly clear that the Swiss entity is actually not a guarantor here, either.

The bonds aim to track the return profile of a BDC index called the MVIS US Business Development Companies Index . Ultimately this is a collection of the largest, most liquid business development companies. From a retail investor perspective, BDCZ is just an alternative to the exchange-traded fund ("ETF") format fund VanEck BDC Income ETF (BIZD).

From a historic total return perspective, BDCZ performs worse than BIZD, while from a risk stand-point the fund contains more factors when compared to an ETF. We are going to further discuss the risk factors below, but they include bankruptcy risk on UBS's part, call risk given the ETN is a bond, and issues associated with the ETN structure.

Overall, the ETRACS MVIS Business Development Companies Index ETN has many structural risks associated with it while its returns do not even match the BIZD ETF. A retail investor interested in BDC returns is best suited to go with BIZD.

Risks

1. Default Risk

As we have seen from the Credit Suisse panic episode, even large systemically important banks can run into trouble. While we do not think UBS will have any issues in the future (it really is the only remaining large Swiss bank), a retail investor needs to be aware that an ETN can default and offer a 0% recovery from a theoretical standpoint.

While ETFs are bankruptcy remote because they own their own collateral, ETN are purely a bond. An investor buying an ETN basically underwrites the issuing bank and its ability to pay the promised return profile. Furthermore, as we have seen from the above UBS disclosure, the bank goes at length toward explaining what entities are backing the bond and which ones are carved out.

2. Call Risk

A bond has a maturity date, and furthermore usually comes with embedded options which give the issuer (i.e., UBS) the ability to call the bond early:

UBS may elect to redeem all outstanding ETNs at any time on any Exchange Business Day (or if such day is not an Exchange Business Day, the next Exchange Business Day) on or after October 17, 2016, as described in the ETRACS Prospectus under the heading "Specific Terms of the ETNs - UBS's Call Right". If UBS exercises its Call Right, the Call Settlement Amount may be less than the Principal Amount of your ETNs.

This basically means that BDCZ is callable at any time given the current date. An investor buying this ETN and being underwater from a price perspective versus his/her entry point, can have the 'surprise' of crystalizing that loss forever if the fund gets called. While we do not expect UBS to do that, you never know when certain tax implications or business decisions (say the exiting of the ETN business) can force UBS to call the bonds.

3. Market Risk

This is the only risk that an investor will also find with an ETF. This basically addresses the investment profile in the portfolio of BDC companies that compose this fund:

A potential severe recession could put pressure on the underlying credit portfolios held by the BDCs, and in turn move their NAVs significantly lower.

Performance

The fund lags when compared to a simple, vanilla exchange traded fund that invests in business development companies:

We can see the two funds are highly correlated, however, BDCZ lags by more than 10% on a 5-year lookback. While not extremely significant on an absolute basis, that return represents more than a quarter of the total number posted. In that context, the underperformance is quite significant.

Conclusion

In our mind, ETNs are structurally flawed for retail investors since they include significant non-visible risks. However, in many instances there are no other alternatives, or the structure is done as tightly as possible (the removal of the call risk via long maturity dates for example, or a very strong bank issuer). The main reason a retail investor should buy into an ETN versus an ETF is the lack of alternatives or the standout performance. We see many leveraged ETNs with very specific investment focuses fall in the "lack of alternatives" bucket, while not many ETNs post outstanding performances when compared to their vanilla ETF peers.

BDCZ does not fall in any of the above categories. The ETN runs many risks associated with its structure (call risk, default risk, etc.) while it does not offer a superior return to a plain vanilla ETF in the business development company space. In our view, a retail investor is best served to look at ( BIZD ) when considering obtaining exposure to the BDC asset class.

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