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Here's how exchange traded notes work.

When is debt not ordinary debt? When it’s packaged as exchange-traded notes. An exchange-traded note (ETN) is pegged to a market index, but functions like a bond. At maturity, ETNs pay out the return of the index it tracks. However, it won’t make regular interest payments like a bond. If you’re considering using ETNs to diversify your portfolio, you may want to consider some of their more eccentric features before diving in.

Exchange-Traded Notes Explained

Exchange-traded notes are a debt security much like a bond. They are typically issued by financial institutions which take the resulting capital as a private gain in the same way that they would an ordinary loan.

Unlike a traditional bond, however, exchange-traded notes do not pay a fixed interest rate. Instead they pay returns linked to a specific market metric, index or other benchmark. For example a bank might issue an ETN linked to the S&P 500. In this case, at maturity the note would issue a return defined by the S&P 500 index’s performance over the note’s lifetime.

You, the lender, do not know what your return will be on this note. With a traditional bond, the interest rate is fixed and you know what you will receive upon maturity. An ETN bases its return entirely on the performance of its linked metric.

The issuing institution can link an ETN to virtually any metric it chooses. It is an unsecured debt obligation backed only by the promise of the borrower to make payment in full and to calculate that payment accurately.

ETNs vs. ETFs

Here's how exchange traded notes work.

Despite their similar names, exchange-traded notes have little in common with exchange-traded funds (ETFs).

An ETF is a fund which owns a series of assets designed to track a given index. For example, a precious metals ETF might own several commodities contracts in gold and silver or shares of stock in various mining corporations. In this way the fund would link its performance to that of the precious metals market overall. An ETF linked to the Dow Jones Average might purchase a representative sample of Dow Jones Index stocks (or even all of them).

Investors in an ETF receive a share of ownership in this fund and the assets that it holds.

An ETN, by contrast, offers no ownership shares. Unlike a fund, the institution that issues an ETN does not purchase any underlying assets. Instead, the institution merely promises to make a payment based to that metric’s performance. That institution tracks the performance of a linked metric over the life of the note. Once the note expires, that institution calculates payment.

Benefits of Exchange-Traded Notes

Exchange-traded notes provide the security of a debt obligation with the profitability of an investment. Under ideal circumstances, the borrower will be reliable and the linked metric will perform well. In this case the note will offer the returns of a stock with the security of a debt product.

Another advantage to an ETN is that it can provide you with exposure to potentially exotic asset classes. As the Financial Industry Regulatory Authority points out, “[s]ome ETNs provide exposure to familiar, broad-based indexes, while others do so to less familiar asset classes or newer, more complex, or even proprietary indexes.” This can give investors a chance to profit off of sectors they may never otherwise have accessed.

Some ETNs will even counter-indicate against a given market. These “inverse” ETNs are the equivalent of short sales, promising to pay the opposite of market performance.

Risks of an ETN

Remember that this is an unsecured product. There is little, if anything, you can do if the borrower defaults on the note.

An ETN also exposes you to market risk. Unlike a traditional bond, an ETN does not have any guaranteed payment. If the note’s linked metric performs poorly, you might get little to nothing back for your money. At worst, if the metric declines in value, you could even receive less back than your principal.

This market risk is compounded by what is known as “closure.” Most ETNs will come with an option for the borrower to redeem their note before its stated maturation date. Typically, this will happen through redemption or early maturation. In both cases the issuing institution will pay you for the ETN based on the current value of its linked metric. This can result in you earning less than anticipated or even taking a loss based on current prices.

Finally, while an ETN can help you indirectly invest in exotic markets, this carries potentially significant risks. A note that is linked to emerging markets or metrics with which you are otherwise unfamiliar is one that you might be ill-prepared to evaluate. This makes it significantly more likely that you might lose your investment through a bad bet.

The Market For ETNs

Here's how exchange traded notes work.

Issuers list exchange-traded notes on, you guessed it, an exchange. Traders buy and sell them based on a number of different factors. Performance of linked metrics, creditworthiness of the borrowing institution, and time until maturity are all considered by traders.

Notes may even trade for more than their current value. If traders believe that the linked metric will perform well and the borrowing institution will pay its debts, an ETN’s value rises.

The borrowing institution can issue new ETNs and redeem existing ones at current market values. It will typically do this to stabilize the price of its notes, controlling how much it earns and pays. If the note appears overvalued relative to its index, the institution may issue new notes to bring the price down. If the note appears undervalued, the institution may redeem some existing ones to raise the price.

By issuing new notes during periods of high value, it can raise more capital. Meanwhile, redeeming low-value notes can prop up that market. This is how the market for ETNs is, ideally, kept stable for investors. However, when an issuer redeems an ETN, it does so based on the linked metric, not the market price of the note.

Taxes and ETNs

Exchange-traded notes don’t actually hold any of the assets that they are linked to. As a result they avoid the tax implications of trading in and out of an exchange-traded fund or an indexed mutual fund.

As the holder of an ETN, you are not subject to the short term capital gains taxes created by those products’ frequent tax events. Instead you only pay taxes once, when you sell the note and profit off of it.

Bottom Line

Exchange-traded notes can yield significant returns is the borrower is solid and the market plays along. It can also open up more exotic investments and minimize your investment tax hit.

An ETN can also fall with the market and expose you to risks you wouldn’t find in bonds. If the borrower isn’t so reliable, they could default on the note altogether. If you’re unfamiliar with ETNs or uncertain about their risks, consider consulting a financial advisor.

Investment Tips

  • Exchange-traded notes aren’t a great fit for everyone’s portfolio, but a financial advisor can determine if they belong in yours. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • For those who think ETNs might be a little too risky, there are somewhat safer bond options out there. SmartAsset can show you not only the different types of bonds available, but how to buy them if you’re interested.

Photo credit: ©iStock.com/William_Potter, ©iStock.com/PeopleImages, ©iStock.com/Doucefleur

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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