What Is an Exchange-Traded Note?
An exchange-traded note, known as an ETN, is a senior, unsecured, unsubordinated debt security that is linked to the performance of a market index and trades on a securities exchange. ETNs are unsecured debt obligations of financial institutions. Unlike an exchange-traded fund, an ETN does not own an underlying portfolio of assets, so the holder is subject to the creditworthiness of the issuer.
ETNs are complex and involve many risks, and an investment in one can result in the loss of the entire investment.
Where Exchange-Traded Notes Fit
Exchange-traded products are investment products that are listed and traded on national securities exchanges. These investment products include exchange-traded funds, exchange-traded commodity trusts and exchange-traded notes. Exchange-traded products are listed on an exchange and can be bought and sold throughout the trading day like a stock.
The exchange-traded products differ in how they are built. Exchange-traded funds are investment companies registered under the Investment Company Act of 1940. Other types of exchange-traded products are pooled investment vehicles with shares that trade on a securities exchange, but they are not investment companies under the Act because they do not invest primarily in securities. Such products may invest primarily in assets other than securities, such as futures, currencies, or physical commodities. Still other exchange-traded products are not pooled investment vehicles. Exchange-traded notes belong to this group, and they are senior, unsecured, unsubordinated debt securities that are linked to the performance of a market index and trade on securities exchanges.
An exchange-traded product's prospectus and related documents, such as a pricing supplement, will include its investment objectives, investments, risks, fees and expenses and other important information.
Reading the Words: Unsecured, Senior and Unsubordinated
Three words in that description come from the debt markets. In the corporate bond market, bonds that have no collateral pledged to them are unsecured and may be called debentures. In the case of a secured bond, the company pledges specific collateral. A debenture has a general claim on the company's assets and cash flows.
Debentures may be classified as either senior or junior (subordinated) debentures. If the company defaults, holders of senior debentures will have a higher priority claim on the company's assets and cash flows than holders of junior debentures. An ETN described as senior and unsubordinated is therefore not a junior (subordinated) debt security.
Credit or default risk is the risk that a company will fail to timely make interest or principal payments and thus default on its bonds. In an ETN, the same risk attaches to the issuer, which is typically a bank or other financial institution.
How an Exchange-Traded Note Works
An ETN represents a promise to pay a return at maturity that reflects the performance of a benchmark. ETN payment terms are linked to the performance of a reference index or benchmark, representing the ETN's investment objective.
An ETN is very different from a traditional corporate bond. A traditional corporate bond pays a stated rate of interest, while the return on an ETN is based on the performance of a reference index or benchmark, minus any investor fees. Repayment at maturity may be greater than or less than par value.
ETNs generally do not pay interest to their holders. Some ETNs might make periodic distributions, but others do not.
Payments on ETNs may be linked to well-known broad-based securities indexes or to indexes tied to emerging markets, commodities, volatility, a specific industry sector, foreign currencies, or other assets.
Many ETNs are issued with maturities of 20 or 30 years, and many are not intended to be held to maturity.
A Debt Obligation, Not an Ownership Interest
An ETN is an unsecured debt instrument. ETNs are not pooled vehicles, and they do not buy or hold shares of stock or other underlying assets. The issuer is typically a bank or other financial institution.
A purchaser of an ETN is subject to the creditworthiness of the issuing financial institution and would be a creditor if the issuer defaults on payments due. An ETN is a debt security, and investors who buy corporate bonds, another kind of debt security, are lending money to the company issuing the bond.
From Issuance to Maturity
ETNs issue and redeem notes in creation unit sizes, generally 25,000 to 50,000 notes. The purchasers of the creation units split them up to sell the individual notes to investors in transactions on an exchange. In an exchange-traded fund, a creation unit is a large block of shares, typically 50,000 shares or more, usually sold in in-kind exchanges to authorized participants. Authorized participants are financial institutions, which are typically large broker-dealers, that enter into contractual relationships with exchange-traded funds to buy and redeem creation units of fund shares.
ETNs are listed on an exchange and may be bought and sold at market prices. Issuers have primary control over the issuance and redemption processes.
Investors may initiate the redemption process before an ETN's maturity date, but a minimum number of notes is required to initiate a redemption, usually 25,000 or 50,000. Redemption is not generally a practical source of liquidity for most retail investors.
Callable or redeemable bonds are bonds that can be redeemed or paid off by the issuer prior to the bonds' maturity date. Some ETNs may likewise be called at the issuer's discretion, meaning they can be subject to early redemption or an accelerated maturity date. If an ETN is called, its value when called may be less than the market price that the holder paid, or even zero.
If the ETN is held until maturity, the issuer pays the return the note promised, which may be greater than or less than par value.
Exchange-Traded Note and Exchange-Traded Fund Compared
ETNs are often confused with exchange-traded funds. ETNs and exchange-traded funds are both traded on a securities exchange and can be bought and sold throughout the day, but there are important differences.
Exchange-traded funds are registered investment companies. An investor in an exchange-traded fund owns shares of a fund, which represents an ownership interest in an underlying portfolio of assets. Most exchange-traded products are structured as exchange-traded funds registered under the Investment Company Act of 1940. An exchange-traded fund discloses the value of its portfolio of assets to investors by publishing an end-of-day net asset value and by disseminating an estimate of its value generally every 15 seconds during the trading day, which is sometimes called an intraday indicative value. An exchange-traded fund issues and redeems its shares in creation units, at their net asset value.
An ETN, in contrast, does not own an underlying portfolio of assets. ETNs share some characteristics with exchange-traded funds. ETNs also issue and redeem notes in creation unit sizes, and, as with exchange-traded funds, the creation and redemption process affects the number of notes trading at any point in time.
There is a fundamental difference between the two. As ETNs do not own assets, the value of the ETN is calculated using a described formula rather than net asset value when new ETNs are issued. An exchange-traded fund is a fund that holds the assets it tracks. An ETN is an unsecured debt obligation, and its value is tied to the strength of the issuer.
Indicative Value and Market Price
ETN issuers issue and redeem notes as a means to keep the ETN's price in line with a calculated value. This value is called the indicative value. It is calculated and published at the end of each day by the ETN issuer. Issuers publish a value at the conclusion of each trading day representing the amount an issuer would be obligated to pay the investor. Market prices may vary from these published values. An ETN also has intraday indicative values, and its market price can be compared with the closing and intraday indicative values. An ETN's prospectus describes how the value of the note is determined on any particular trading day, as well as how the value of the reference index or benchmark is calculated.
An ETN's market price can deviate, sometimes significantly, from its indicative value. An ETN might trade at a premium to its indicative value if the issuer suspends issuance of new notes. Buying at a premium can lead to significant losses for an investor. ETNs can trade at premiums or discounts to their indicative value, especially when the issuer has suspended further note issuances.
Buying and Selling
Like stocks, exchange-traded products typically involve a bid-ask spread. The bid-ask spread is the difference between the highest price a buyer will pay and the lowest price at which a seller will sell at any given time. The spread might be almost zero for some exchange-traded products but much wider for others.
Unlike with a mutual fund, retail investors may transact at prices that can deviate from the underlying value of the exchange-traded product. An investor can compare the market price with published estimates of the product's value and can consider order types other than market orders.
Investors purchasing or selling ETNs or shares of an exchange-traded product through an investment professional typically pay a brokerage commission on each transaction, as with purchases of individual stocks. Exchange-traded products have expense ratios, like mutual funds, calculated as a percentage of the assets invested. For an ETN, the return is based on the performance of the reference index or benchmark, minus any investor fees.
It may be appropriate to consult a tax professional before investing in an ETN.
Risks of an Exchange-Traded Note
The risks of an ETN include complexity, credit risk, market risk, leverage, price volatility, and liquidity risk. The sections below take the main ones in turn.
Credit Risk
ETNs carry credit risk, which is the risk that the issuer will default on the note. The value of an ETN is tied to the strength of the issuer. If the issuer defaults on the note, the holder might lose some or all of the investment.
Other issuer actions may also affect the price of an ETN.
Market Risk
ETNs also expose investors to the performance risk of the reference index or benchmark. Exchange-traded products are market-linked products and, just like any stock, can increase or decrease in price.
Leveraged and Inverse ETNs
Some ETNs offer leveraged exposure. A leveraged ETN pays a multiple of the performance of the reference index or benchmark. Other ETNs, called inverse ETNs, are calculated based on the opposite of the performance of the reference index or benchmark.
Leveraged, inverse, or inverse-leveraged ETNs reset on a daily basis their exposure to the leveraged, inverse, or inverse-leveraged exposure stated in the prospectus. As a result, investors holding such ETNs for more than one day should not expect to receive returns proportional to the exposure stated in the prospectus. The difference can be significant. These ETNs are not typically used as buy-and-hold instruments.
Most leveraged and inverse exchange-traded funds also reset each day, which means they are designed to achieve their stated objective on a daily basis. With the effects of compounding, over longer timeframes the results can differ significantly from their objective.
Liquidity Risk
The liquidity of ETNs varies significantly. If an investor needs to cash out an investment, the investor may not be able to sell the ETN immediately and at a price the investor would consider reasonable. If an exchange-traded product is delisted from its listing exchange and limited to over-the-counter quotation, liquidity can dry up. An exchange-traded product may also have wide bid-ask spreads or trade at a large premium or discount to its value.
Margin Requirements
The Financial Industry Regulatory Authority, known as FINRA, has established higher strategy-based margin requirements for ETNs. Pursuant to FINRA Rule 4210(f)(8)(A), FINRA excluded ETNs from the exceptions available for positions in ordinary investment grade debt securities, listed non-equity securities and other margin eligible non-equity securities, in light of the complex nature of these products. The requirements for leveraged ETNs are increased by a factor commensurate with their leverage, and the margin requirement on a leveraged ETN held long in an account is capped at 100 percent of its value. ETNs and options on ETNs are not eligible for portfolio margining under Rule 4210(g).
Sales Practice
FINRA has described a complex product as a product with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks. In a regulatory notice on complex products, FINRA names exchange-traded notes among the other complex products. The same notice reminds members of the application of Regulation Best Interest when broker-dealers make recommendations to retail customers.
An earlier FINRA notice on complex products describes a complex product as a security or investment strategy with novel, complicated or intricate derivative-like features. It says firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted. Each firm is responsible for determining which products require enhanced compliance and supervisory procedures.
A broker should only recommend transactions and investment strategies that are suitable for the customer based on the customer's investment profile.
The content outline for the Securities Industry Essentials examination lists exchange-traded notes under Topic 2.1.9, Exchange-traded Products, in Section 2, Understanding Products and Their Risks. The outline lists the types of exchange-traded products as exchange-traded funds and exchange-traded notes. Candidates should check the current outline before the examination.
Common Misunderstandings
An ETN owns the securities in the index it follows. An ETN does not own an underlying portfolio of assets. It is an unsecured debt obligation of the issuer.
An ETN carries only the risk of its index. An ETN also carries the credit risk of the issuer. The holder is subject to the creditworthiness of the issuer and might lose some or all of the investment if the issuer defaults.
An ETN is an exchange-traded fund by another name. An exchange-traded fund is a registered investment company that represents an ownership interest in an underlying portfolio of assets, while an ETN is an unsecured debt obligation of its issuer.
An ETN is a registered investment company. Exchange-traded funds are investment companies registered under the Investment Company Act of 1940, and exchange-traded notes belong to the group of exchange-traded products that are not pooled investment vehicles.
An ETN pays interest like a bond. ETNs generally do not pay interest to their holders. Some ETNs might make periodic distributions, but others do not.
An ETN trades at its indicative value. An ETN's market price can deviate, sometimes significantly, from its indicative value.
An ETN stays in place until maturity. Some ETNs may be called at the issuer's discretion, meaning they can be subject to early redemption or an accelerated maturity date.
A leveraged or inverse ETN suits a buy-and-hold investor. These ETNs reset their exposure on a daily basis, and they are not typically used as buy-and-hold instruments.
Any holder can redeem an ETN early whenever it chooses. A minimum number of notes, usually 25,000 or 50,000, is required to initiate a redemption, and redemption is not generally a practical source of liquidity for most retail investors.
Key Points
An ETN is a senior, unsecured, unsubordinated debt security linked to the performance of a market index that trades on a securities exchange.
An ETN is an unsecured debt obligation of a financial institution and does not own an underlying portfolio of assets.
The holder is subject to the creditworthiness of the issuer and would be a creditor if the issuer defaults on payments due.
An exchange-traded fund is a registered investment company that represents an ownership interest in an underlying portfolio of assets, while an ETN is an unsecured debt obligation of its issuer.
An ETN can be called at the issuer's discretion, can trade at a premium or discount to its indicative value, and may be hard to sell at a reasonable price.
Leveraged and inverse ETNs reset their exposure daily and are not typically used as buy-and-hold instruments.
