Investors often invest in the ownership of debt. In fact, it’s that concept that keeps the thriving bond market alive. While most forms of debt instruments come with predetermined rates of return, paying interest or offering a premium to the purchase price at maturity, there are some that mix the concept of debt with the concept of equity ownership, providing returns equal to the returns generated by underlying assets.
One such investment option is known as the exchange-traded note, or ETN.
These investments are a form of debt, but aren’t attached to an interest rate. Instead, the issuer of the note agrees to pay returns equal to the returns of an underlying index.
What Is an Exchange-Traded Note (ETN)?
ETNs are what you would expect if an index fund and a bond had a baby, creating a financial product that comes with characteristics of its figurative parents. Like index funds, ETNs track the results of an underlying index, with investors experiencing gains when the benchmark is trending up and losses when it trends down.
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Like with bonds, the investor doesn’t own shares of the issuing company. Instead, the investor offers debt capital to the issuer and agrees to a predetermined maturity date, generally ranging from 10 to 30 years, at which point returns will be paid to the investor.
Put it all together and you end up with a debt security product that comes with a predetermined maturity date, yet is capable of being traded on stock exchanges like the Nasdaq and New York Stock Exchange with prices that fluctuate like stocks.
How Exchange-Traded Notes Work
The lifecycle of these investment opportunities starts with the ETN issuer, or the company looking to raise funds through the offering, which is generally a financial institution. This issuer determines the original price of shares, number of shares to be issued, and maturity date of debt in the transaction based on market conditions and the amount of money the issuer plans to raise.
The provider then makes all of this information available through an official prospectus and lists shares for sale. If interested in the offer, the investing community can purchase shares.
From there, the ETN will act as a stock, with market prices that fluctuate based on multiple factors, the most important being:
- The Performance of the Underlying Index. ETNs provide returns based on an underlying index or benchmark, much like ETFs, meaning the benchmark’s performance is crucial to the movement in the value of the note. Should the index generate gains, so too will the note, and vice versa.
- The Maintenance of Issuer Credit. Like with bonds, ETN owners do not own shares of the company itself; you’re simply investing in a promise from the institution that issued the debt to repay your money as agreed. As such, if there is a sudden downgrade in the issuing institution’s credit rating, you can expect to see significant declines in the price of the notes it has issued. Conversely, an unexpected upgrade can be a catalyst for significant gains.
- Supply & Demand. ETNs trade on public stock exchanges, which means the market price of these assets is determined by the investing community. If there is more demand than supply, prices will rise; in some cases the price will outpace the underlying assets the note tracks. Of course, that means when supply is high and demand is low, the price of the note could fall below the value of the assets it was designed to track.
Exchange-Traded Notes vs. Exchange-Traded Funds (ETFs)
Exchange-traded products, or ETPs, are popular options among the investing community. ETNs and the more familiar exchange-traded funds (ETFs) are the two most common types of these products. While these are somewhat similar financial products, there are a few key differences investors should consider when deciding between ETNs and ETFs:
Secured vs. Unsecured
Let’s address the elephant in the room first. When you purchase an ETF, you’re purchasing ownership of a percentage of the portfolio managed by the ETF.
This means you will own small amounts of each company held in the fund’s portfolio, acting as security for your investment. Should the issuer of an ETF go out of business, you, as an investor and partial owner of the company, have claim to assets held by the company.
When it comes to ETNs, there’s a very different story.
Owners of these notes don’t actually own any securities. These are 100% unsecured debts, meaning if the issuer of the note defaults, the investor may receive little or none of their investment dollars back.
ETFs don’t have maturity dates. If investors continue to pile their money into these funds, they’ll live on forever. On the other hand, ETNs act as a form of debt with a predetermined maturity date, generally ranging from 10 to 30 years. When the note matures, the institution that issued the note is expected to pay the investor based on the changes in the underlying benchmark. At this point, the note is closed for good.
Both ETFs and ETNs are at the mercy of market conditions because their returns are based on the performance of the assets they were developed around. However, ETNs come with a far higher level of risk than ETFs.
As an unsecured debt, a default by the issuing institution could result in the loss of your entire investment, while a reduction in the firm’s credit rating will lead to declines. At the same time, with less demand for ETNs than ETFs, there’s an inherent liquidity risk, meaning you may have a hard time finding a buyer if you decide it’s time to liquidate your position.
While ETFs come with some liquidity risk, they tend to be far more liquid than ETNs. ETF investments aren’t forms of debt, so there’s far less risk of default or credit issues leading to declines. While the ETF may decline if companies held in its portfolio decline, the portfolio won’t fall too far thanks to the heavy diversification generally seen among these investments.
Pros and Cons of ETNs
As with any investment vehicle, ETNs come with unique benefits and risks. It’s important to gauge the pros and cons of an investment before risking your hard-earned money. When it comes to ETNs, the most important pros and cons to consider include:
Pros of ETNs
Investors often enjoy the perks that come along when you mix traditional index funds with debt, resulting in a product that provides the benefits of both. Here are the most raved about perks:
- Larger Potential Gains. Most debt instruments come with minimal potential for returns, but that’s not the case with exchange-traded notes. With these notes, investors have the potential to generate significant returns if the value of the note’s underlying benchmark makes a run for the top.
- Easy Access. Finally, ETNs trade on major stock exchanges, making it possible for everyday investors to easily get their hands on these products and buy and sell them through their preferred brokerage account.
Cons of ETNs
At first glance, ETNs may seem like a great investment opportunity, but it’s important to consider the risks before diving in.
- Exposure to Credit Risk. Returns on these notes are dependent on the issuing institution’s ability to pay ETN investors on time as agreed. As a result, the credit rating of the issuing firm is overwhelmingly important. Defaults and downgrades have the potential to greatly diminish returns, leading to the loss of the investors’ entire principal investment in some cases.
- Liquidity Risk. These notes are relatively illiquid assets compared to ETFs, mutual funds, and index funds. That’s because fewer investors take advantage of these investment vehicles. As a result, when you decide it’s time to exit your ETN investment, you may have a hard time finding a buyer, resulting in prolonged, unwanted ownership of shares.
- No Ownership. When investing in ETNs, you don’t own the underlying assets the fund is based on. Instead, the investment is based on an agreement by a large institution to pay you the returns generated by the underlying asset.
- Tracking Error Risk. Although the ETN issuer agrees to provide returns equal to the returns offered by the underlying benchmark, there’s always the potential for tracking error risks throughout your ownership of the note leading to points at which the value of the note moves at a different rate than the value of underlying assets. Because ETNs are exchange-traded and shares priced based on supply and demand, if too many people dump their shares of the ETN, it could end the day in the red even on a positive day for the underlying assets.
- Volatility Risk. Debt securities are generally prized for their stability. But because ETNs track an underlying index, they don’t enjoy the same level of stability. Instead, the note has the potential to experience the same level of volatility seen in the value of the index it tracks.
Should You Invest in ETNs?
With so many investment products available today, there are few investors who would actually benefit from an ETN investment. There are simply better options.
ETNs are designed to track an underlying index based on a promise by a financial institution to pay returns in exchange for an unsecured injection of funding. These funds charge expense ratios that are comparable to — and in many cases higher than — those of ETFs and mutual funds, while providing no real ownership of underlying assets.
As a result, investors are generally better served investing in other investment-grade funds that track underlying indexes through ownership of the assets listed on the index. In doing so, investors will eradicate credit risk, default risk, and much of the liquidity risk they would have to accept in ETNs.
Ultimately, investing is all about risk and reward, and with other ways to produce a similar reward with greatly reduced risk, there aren’t many reasons to put your money into ETNs.
Tax Treatment of ETN Gains
If you do decide to invest in exchange-traded notes, it’s important to understand the tax implications of your decision.
Taxes on investment returns are based on one major factor: time. Gains from investments held for less than one year are considered short-term capital gains, while gains from investments held for a year or longer are considered long-term capital gains.
Short-term gains will come with a tax rate equal to your standard income tax rate, but long-term gains are charged the significantly lower capital gains tax rate.
Considering most ETNs come with a maturity date ranging from 10 to 30 years, if you hold your investment to maturity, you’ll pay the lower capital gains tax rate. However, if you decide to sell your shares of an ETN to the highest bidder less than a year after your purchase, be ready to pay your higher, standard income tax rate on any gains.
While ETNs have enjoyed some success in the market, the simple fact is that there are better options to consider to make your hard-earned dollars work for you. Unfortunately, these funds take on the worst parts of the two investments they are related to. Investors must accept both the volatility of the stock market and the risk of debtor defaults and credit impairments that go with owning bonds.
As such, most investors are better served with investments in ETFs, mutual funds, and index funds.
Nonetheless, if you do decide to invest in ETNs, keep in mind that research is the foundation of strong investment decisions. Not all notes are created equal, and the more you know about the notes you purchase, the better your chances of generating profits.