Exchange-traded notes also known as ETN belong to a different category of debt instruments like senior, unsubordinated and unsecured debt. ETN is issued by financial institutions or entities like banks. Generally, they are held till maturity but if the investor wants, he can sell them anytime. The decision depends on the investor’s will. One of the drawbacks of investing in ETN is the investor is exposed to the possibility of credit risk. However, the returns earned by an investor are associated with the stock index as the price of ETN fluctuates like the price of a stock. An investor must understand its working procedure, features, benefits as well as the risks associated while investing in ETN.
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How do Exchange-Traded Notes Work?
ETN is issued by a financial institution or entities like banks, that provides a return to investors based on the performance on the stock index based on the beginning and end of the maturity period.
Just similar to a bond, the issuer will pay the interest at maturity. However, the investors can exercise the exchange-traded notes as they prefer. The typical maturity period for an ETN is between 10-30 years. Although ETN is similar to bonds they do not pay any interest.
At the maturity period the investor is paid in cash based on how the stock index performed from the beginning to the end of the maturity period and the investor’s fees i.e., the fees that are to be paid by the investor to the financial institution is deducted. In simple words, the investor doesn’t have to pay any additional cash to the institution as it is adjusted by the institution from the cash it’ll pay to the investor.
Despite not being the owner of the securities, investors are still provided the returns that are generated from the performance of the stock index. Just like a debt instrument the investor should trust the issuer to generate a good return. However, the investor should also be aware of the credit risk and the losses that he may incur before investing in ETN.
Characteristics of ETN:
Issuance: ETNs are issued by large financial institutions or entities like banks.
Tracking Of Asset Performance: ETNs track the performance of the underlying asset. They do not own any part of the asset. For example, XYZ co. follows a stock index but does not buy stock.
Liquidity: Exchange-traded notes are traded through the secondary market (exchange). Investors can either hold ETN till the maturity period i.e., typically between 10-30 years or redeem it before maturity. However early redemption fees will be deducted by the issuer from the overall return the investor earns.
Expense Ratio: ETNs may charge a certain annual expense ratio. Expense ratios are charged by the fund manager and it typically ranges from 0.2% to 1.5% depending on the level of convolution.
Advantages of ETNs:
Tax Benefits: An ETN enjoys favorable tax treatment. Since investors do not receive any interest payments or dividends, they earn the returns at the maturity or before whenever the ETN is redeemed. The returns generated from ETN are considered to be long-term capital gains and the tax rate charged on them is lower as compared to short-term gains.
Tracking Accuracy: Although ETN does not own the underlying asset, it tracks the performance accurately. Investors are assured to receive the full value of the promised principal less any fees. This helps to eliminate the losses that the investor might face due to tracking errors.
Flexibility: ETN is flexible than other debt instruments. They can be purchased and redeemed on any trading day depending on the investor’s preference.
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Disadvantages of ETN:
Credit Risk: One of the drawbacks faced by investing in ETNs is exposure to credit and market risk. Credit risk takes place when the issuer is unable to repay the amount to the investor. A decline in the issuer’s credit rating can impact the value of ETN.
Tracking Errors: At times exchange-traded notes face the issue of tracking errors. Tracking errors takes place when the price of the exchange-traded note and the index price do not correlate
Illiquidity: Although exchange-traded notes are traded daily there is a certain restriction imposed on the issuer who wants to redeem the security. It restricts the investor redemption limit to once a week. In other words, the investor can redeem in blocks of units only once a week.
Exchange-traded notes are issued by a financial institution or entities like banks. It tracks the stock index. An investor is restricted to redeem securities once a week. It is advised to check the issuer’s credit rating before investing in Exchange-traded notes.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.