An exchange-traded note (ETN) is a loan instrument issued by a financial entity, such as a bank. It comes with a set maturity period, usually from 10 to 30 years. It can be traded based on demand and supply.
Unlike other debt tools, exchange-traded notes will not produce any interest revenue for the lender. The gains or losses of the investor are derived from the performance of an asset class or index that it tracks. The investor may opt to sell the ETN before its maturity or keep it until maturity to get its returns.
An exchange-traded note (ETN) is a loan instrument issued by a financial entity, such as a bank.
Usually, an ETN is issued by financial institutions, and its return is based on the performance of a stock index.
Exchange-traded notes do not give holders control of the assets but merely receive the return that the index generates.
Workings of Exchange-Traded Notes (ETNs)
Exchange-traded notes (ETNs) are issued by an underwriting bank, and their return is based on the performance of a stock index. They are a type of bond that pays the returns of the index that it tracks at maturity. However, ETNs do not pay interest as bonds do.
When the exchange-traded note (ETN) matures, the financial institution offers the investor cash in an amount that reflects the underlying index’s performance. As ETNs trade on major markets such as futures, the investors can sell and buy the notes and make money from the gap between buying and selling rates, deducting any fees.
Exchange-traded notes do not give holders control of the assets but merely pay the return that the index generates. Consequently, ETNs are similar to debt instruments. Investors must assume that the issuer can make a successful return based on the underlying index.
Characteristics of ETNs
1. Asset ownership
An exchange-traded note does not own the underlying assets of the indices; instead, it tracks them. For example, the ETN follows the gold index but does not buy any gold.
2. Unsecured debt
An investor relies entirely on the issuer’s creditworthiness and its promise to repay the principal investment and the profits or losses suffered. During the issuance of the exchange-traded note, the issuer does not provide any collateral that can be exchanged to cover for the losses suffered by the investor.
3. Liquidity offered
Exchange-traded notes (ETNs) can be traded on trading days through the exchange or directly with the issuing bank. Early redemption is typically on a weekly basis and incurs a redemption fee.
4. Expense ratio
Including most financial instruments, the exchange-traded notes (ETNs) often come with an annual expense ratio. The expense ratio is the fee that the fund manager charges for covering the management of the fund and other expenses.
Benefits of ETNs
1. Tax savings
Unlike with mutual funds, investors do not receive any monthly dividends or interest, nor are there any capital gains distributions made during the year. Instead, any gain (or loss) is deferred until the ETN is sold or matures. It is treated as a long-term capital gain, which receives a more favorable treatment (lower tax rate of 20%) than short-term capital gains.
2. Access to some markets
The markets for particular securities – such as currency, commodities futures, and international markets – are not easily accessible to small investors since they come with a high commission price and high minimum investment prerequisite. ETNs do not include any such limitations that make them available to even small institutional investors.
3. Accurate tracking of performance
The exchange-traded note (ETN) does not own any underlying asset. Thus, unlike an exchange-traded fund, rebalancing is not required. The ETN replicates the value of the index or class of assets that it tracks.
ETNs can be bought or sold in normal trading hours of the securities exchange or sold back to the issuing bank on a weekly basis. Investors can monitor their performance of the debt instrument much like a stock investment.
Limitations of ETNs
1. Shortage of liquidity
Exchange-traded funds (ETFs) will be exchanged during the day, encouraging a flexible trader to take advantage of price fluctuations, but the exchange-traded note (ETN) is less liquid than stocks. Many hoping to throw away huge blocks of units are given the chance to do so only once per week, leaving investors vulnerable to risks related to the holding period in the process.
2. Credit risk
Any transaction performed by an investor exposes him/her to market risk, which is the possibility that the underlying asset will underperform. The exchange-traded notes (ETNs) also come with credit risk; if the borrowing institution defaults, the investor will not get back the principal and the return. Even negative news about the issuer may affect the price of the exchange-traded note (ETN).
3. Few investment options
The demand for exchange-traded notes (ETNs) is less than many other products, so these are few options, and costs can differ widely. The issuing entities do their best to keep valuations constant, but the methods used can cause fluctuations.