In today’s diverse financial landscape, Exchange-traded notes (ETNs) have emerged as a diverse investment option. Unlike other bonds, ETNs are structured products that track the performance of the underlying asset. With their unique characteristics and range of offerings, ETNs have caught the attention of investors who are seeking alternative avenues for potential returns. In this article, we will delve into ETNs and their benefits.
What Is an Exchange Traded Note?
Exchange-traded notes (ETNs) are unsecured debt securities traded on major security exchanges. Similar to exchange-traded funds (ETFs), ETNs are considered bonds, and their returns are determined by the performance of the underlying index or asset rather than by a maturity period. ETNs can be bought and sold based on the performance of the index they track. However, it’s important to note that ETNs do not possess ownership of the underlying asset, and unlike traditional bonds, investors do not receive interest or dividends.
How Does An Exchange Traded Note Work?
Typically, ETNs are issued by banks or financial institutions, offering returns based on the performance of a specific index upon maturity, minus any associated fees. Investors have the option to hold ETNs until maturity, which can range from 10 to 30 years, or trade them like stocks at the current market price. Profits for investors in ETNs are derived from selling the bonds or waiting until maturity.
However, in the event of the underwriting bank’s bankruptcy, investors face the risk of losing their investment portfolio. Therefore, it’s crucial for potential ETN investors to assess the underwriter’s credit rating. A negative credit rating for the underwriter can negatively impact the value of the ETN shares, potentially leading to a decline in their market value.
What Are the Characteristics of ETN?
Unsecured Debt – An investor invests in ETN based on the creditworthiness of the issuer and the promise to repay the investment along with the profits at the end of the maturity end.
Expense Ratio – Like any other financial product, ETNs come up with an Expense ratio. The fee covers the cost associated with managing the fund and other operational expenses by the issuer.
Liquidity – Investors can trade ETNs for liquidity through an exchange or the issuing bank.
Advantages of Exchange Traded Note
1. Access to New Markets:
ETNs have provided small investors with access to certain asset classes, like commodities futures, which typically have high thresholds, such as minimum investment requirements and high commission prices. ETNs offer an alternative investment vehicle without such limitations, making them accessible to both small investors and small institutional investors.
2. Liquid Structured Product
Unlike traditional buy-and-hold products, ETNs effectively enhance the liquidity of structured products since they can be traded on securities exchanges throughout trading hours. While ETNs may resemble ETFs in structure, they differ significantly from each other. ETNs are essentially debt securities, with their price tied to the performance of the underlying asset.
3. Tax Efficiency
Unlike mutual funds and ETFs, which require fund holders to pay capital gains tax, ETNs are exempt from capital gains tax since they do not involve interest payments or dividend distributions. Additionally, ETNs are classified as long-term capital gains, enjoying more favorable tax treatment with a lower tax rate of 20%.
4. Accurate Tracking
ETNs provide investors with access to a broad-based index without encountering tracking errors. Unlike ETFs, which may face tracking errors due to diversification challenges, ETNs avoid such issues as they do not hold the underlying asset directly. Additionally, the ETN issuer guarantees that investors receive returns identical to those of the underlying index minus any associated fees.
Risks Associated With ETN
1. Risks Due to ETN Issuer
The repayment hinges on the performance of the underlying index at the time of maturity. If the index goes down or fails to cover the translation fees, the investor will likely get lower-than-expected returns.
Moreover, to get returns from the index depends entirely on the issuer’s financial viability. Thus, based on the credit rating of the issuer, the ETN value could go down. Furthermore, investors should also consider the possibility of the issuer going bankrupt or defaulting on the bond.
Investors also need to be aware of closure risk. The issuer might close the ETN before the maturity period, and in this scenario, investors will get returns based on the prevailing market price. If the prices are lower than the purchase price, investors may incur a loss.
2. Risks in Tracking an Index
Normally, ETN prices should mirror the index closely. However, there are instances where they may not correlate well, known as tracking errors. These errors occur when the ETN price deviates from the underlying index, often due to credit issues with the issuer.
3. Risks From Liquidity
If a bank or financial institution temporarily suspends the issuance of new ETNs, the limited supply of ETNs can significantly increase their value. Consequently, ETNs may sell at a premium compared to the value of the index they track. Conversely, if additional ETNs are issued, the market may experience a surplus supply, causing the price of ETNs to decline.
What Is the Difference Between ETF and ETN?
Both ETF and ETN have lower fees compared to mutual funds are are easier to understand because they mirror the investments of various indexes and benchmarks.
| ETN | ETF |
| Structure similar to debt investments | Structure similar to mutual investments. |
| Investors do not own any part of the underlying asset. | Investors own shares of the underlying asset. |
| Returns may be distributed after or before maturity | Returns are distributed periodically. |
| Taxes are paid after the maturity is over, or the investor sells the ETN. | Taxes are paid when the dividends are issued. |
Conclusion
Overall, Exchange Traded Notes (ETNs) are unsecured debt bonds issued by financial institutions, offering investors the opportunity to gain exposure to various assets. Despite their benefits, such as tax efficiency and precise index tracking, investors should also be careful of the risks associated with it.
