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Your Guide to Investing in Exchange-Traded Notes (ETNs)

Written by Samuel Taube
Posted July 12, 2020

These are dark times for income investors. 

The S&P 500 yields less than 2% at the time of writing, and the 10-year Treasury yields less than 1%. These payouts are woefully inadequate for most investors’ needs, and many have started to look outside of the conventional stock and bond markets to compensate. 

One high-yielding product that is starting to see renewed attention on investing forums is the exchange-traded note (ETN). Popular notes like the JPMorgan Alerian MLP ETN (NYSE: AMJ), which tracks an index of oil and gas partnerships, often yield more than 10%. AMJ’s yield currently sits at 13.57%. 

ETNs can provide investors with yields that are hard to find anywhere else, but they’re also unique and complex securities that carry an unusual set of risks...

What Is an Exchange-Traded Note (ETN)? 

You might assume that ETNs are close relatives of exchange-traded funds (ETFs)... but you’d be wrong. Both can be bought and sold on stock exchanges during normal trading hours, as indicated by the first two letters — but that’s where the similarities end. 

ETNs are unsecured debt instruments issued by financial institutions and track an underlying index of stocks, bonds, or commodities — like the Alerian MLP Index. 

But while ETFs are baskets of securities that continuously track their underlying indexes by buying and selling their components, ETNs don’t actually contain their underlying investments, and they mature like bonds. 

At maturity, an ETN will pay its holder the return on its underlying index over the life of the note. This return is commonly referred to as the ETN’s yield. 

In that respect, ETNs behave less like funds and more like futures contracts. But they have advantages of both types of investments. 

The Advantages of ETN Investing

The substantial yields ETNs pay their holders at maturity aren’t actually interest or dividend payments, and as a result, the notes have considerable tax advantages over mutual funds, ETFs, bonds, and even common stocks. 

Without any taxable income distributions, ETN returns are taxed entirely at the lower capital gains rate upon sale or maturity. 

ETNs also give ordinary investors like us access to assets which can be difficult to find through retail brokerages - commodities, preferred shares, foreign stocks with restrictions on foreign ownership, and so on. 

And unlike mutual funds or ETFs, ETNs track these underlying assets perfectly, without any discount or premium to net asset value (NAV). 

After all, they don’t actually track their underlying asset. They simply pay out its percentage return at maturity, less fees. You don’t have to worry about incompetent portfolio management when investing in an ETN because it has no portfolio to manage. 

But their tax advantages, sky-high yields, and lack of tracking errors are accompanied by a unique set of potential pitfalls which investors must understand before buying in…  

The Risks of ETN Investing

As with ETFs, mutual funds, and other index-tracking products, ETNs can lose value if their underlying assets lose value. But this is just one way ETN investors can get burned. 

They can also get stiffed by an ETN’s issuer in a crisis. After all, the notes are unsecured debt obligations; they’re subject to default risk just like junk bonds. The credit rating of the issuer is a pertinent consideration for ETN investors; a bank credit downgrade can cause that bank’s ETNs to lose value, even if there was no change in the note’s underlying index. 

And like bonds, some ETNs carry a risk of early redemption. Investors in UBS’s ETRAC series of ETNs learned this the hard way back in March when the bank forced them to cash in their notes due to COVID-19-related market volatility — resulting in losses of 60% or more. 

As a relatively small asset class, ETNs can also suffer from occasional liquidity issues. These aren’t necessarily relevant to long-term investors who are looking to buy notes and hold them to maturity, but they can be disastrous for traders. 

Should You Buy? 

As you can see, ETNs provide unmatched yields and tax treatment in these times of low interest rates and volatile stocks, but they come with their own set of risks. 

If you’re considering buying an ETN, make sure it’s issued by a credit-worthy financial institution and that there’s a strong bull thesis for its underlying index.

But if you’re simply looking for high yields, there are much-easier-to-use alternatives — like, for instance, a curated list of dividend stocks from The Wealth Advisory. 

Its editors, income investing experts Briton Ryle and Jason Williams, currently boast an average gain of 95.62% on each position, even during these dark times. Click here to learn more.

Until next time,

Monica Savaglia

Samuel Taube

Samuel Taube brings years of experience researching ETFs, cryptocurrencies, muni bonds, value stocks, and more to Wealth Daily. He has been writing for investment newsletters since 2013 and has penned articles accurately predicting financial market reactions to Brexit, the election of Donald Trump, and more. Samuel holds a degree in economics from the University of Maryland, and his investment approach focuses on finding undervalued assets at every point in the business cycle and then reaping big returns when they recover. To learn more about Samuel, click here.

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