What Are Exchange-Traded Notes (ETNs)?

Exchange-traded notes (ETNs) are types of unsecured debt securities that track an underlying index of securities and trade on a major exchange like a stock. ETNs are similar to bonds but do not have interest payments. Instead, the prices of ETNs fluctuate like stocks.

How Exchange-Traded Notes Work

An ETN is typically issued by financial institutions and bases its return on a market index. ETNs are a type of bond. At maturity, the ETN will pay the return of the index it tracks. However, ETNs do not pay any interest payments like a bond.

When the ETN matures, the financial institution takes out fees, then gives the investor cash based on the performance of the underlying index. Since ETNs trade on major exchanges like stocks, investors can buy and sell ETNs and make money from the difference between the purchase and sale prices, minus any fees.

ETNs are different than exchange-traded funds (ETFs). ETFs own the securities in the index they track. For example, an ETF that tracks the S&P 500 will own all 500 stocks in the S&P.

ETNs do not provide investors ownership of the securities but are merely paid the return that the index produces. As a result, ETNs are similar to debt securities. The investors must trust that the issuer will make good on the return based on the underlying index.

ETNs were first issued by Barclays Bank PLC in 2006. Banks and other financial institutions typically issue ETNs at $50 per share. Part of the market price depends on how the underlying index is performing.

Risk From an ETN Issuer

The repayment of the principal invested depends, in part, on the performance of the underlying index. If the index either goes down or does not go up enough to cover the fees involved in the transaction, the investor will receive a lower amount at maturity than what was originally invested.

The ETN's ability to pay back the principal—plus gains from the index it tracks—depends on the financial viability of the issuer. As a result, an ETN's value is impacted by the credit rating of the issuer. The value of the ETN could decline due to a downgrade in the issuer's credit rating, even though there was no change in the underlying index.

Investors must be aware of the risk that the issuer of an ETN may be unable to repay the principal and default on the bond. Also, political, economic, legal, or regulatory changes may affect the financial institution's ability to pay ETN investors on time.

The financial institution issuing the ETN might use options to achieve the return from the index, which can increase the risk of losses to investors. Options are agreements that can magnify gains or losses where the issuer has the right to transact shares of stocks by paying a premium in the options market. Options are usually short-term contracts, and the premiums can fluctuate wildly based on market conditions.

Investors also have closure risk, meaning the issuer might be able to close the ETN before maturity. In this case, the investor would be paid the prevailing price in the market. If the sale price is lower than the purchase price, the investor can realize a loss. The early redemption feature of an ETN is stated upfront.

Risk in Tracking an Index

The price of the ETN should track the index closely, but there can be times when it does not correlate well—called tracking errors. Tracking errors happen if there are credit issues with the issuer and the price of the ETN deviates from the underlying index.

Risks From Liquidity

If a financial institution decides not to issue new ETNs for a period, prices of existing ETNs could jump significantly due to the lack of supply. As a result, existing ETNs could trade at a premium to the value of the index it tracks. Conversely, if the bank suddenly decides to issue additional ETNs, prices of existing ETNs could fall due to excess supply.

Trading activity for ETNs can be low or fluctuate dramatically. The result can be ETN prices that are trading at far higher prices than their actual value for those looking to buy. Also, these products may sell at far lower prices than their value for investors looking to sell. Due to the varying prices of ETNs, investors who sell an ETN before maturity can realize a large loss or gain.

Tax Treatment of ETNs

Typically, the difference between the purchase price and selling price of the ETN should be treated as a capital gain or loss for income tax purposes. The investor may defer the gain until the ETN is sold or matures. However, investors should seek counsel from a tax professional for any potential tax ramifications that might exist for their specific situation.

Real-World Example of an ETN

The JPMorgan Alerian MLP Index ETN (AMJ) is an energy infrastructure ETN. It tracks companies in the energy sector that are master limited partnerships (MLPs). MLPs are publicly traded partnerships some of which are responsible for building the energy infrastructure in the U.S.

AMJ has over $2.9 billion in assets and an expense ratio of 0.85%. Over the past five years, the ETN has traded between $7 and $26 per share.

It is important that investors consider the risks present with ETNs. These risks include not only the credit risk of the issuer but also the risk that the ETN's share price could decline significantly as in the case of AMJ.