Exchange-Traded Notes–Definitions and Uses: Part 2

This is the second in a series of articles on exchange-traded notes (ETNs). In this article we continue our definitions of ETNs, in particular, their redemptive or indicative value, along with information on trading ETN shares and the tax treatment of ETNs.

REUTERS/Arnd Wiegmann

Definitions

The redemption value or indicative value of an ETN represents the amount of money owed by the issuing institution to investors holding the ETN. At maturity owners of an ETN receive the final redemption or indicative value. As mentioned in the first article in this series, investors may receive the indicative value at any point before maturity, provided they meet the restrictions in the prospectus. Since investors may redeem their shares for the indicative value, it is calculated daily. The indicative value of an ETN and the interest rate of the ETN are typically linked to an index, often a non-equity index, and can be reduced by an “investor” fee.

One important aspect of ETNs, which the prospectuses outline very clearly, is that the variable interest rates of most of these securities are tied to indices that can have negative returns in any given year. The potential for negative returns, combined with the investor fee, presents the real possibility that investors may redeem ETNs for less—perhaps substantially less—than they paid for them. It is not uncommon to read in the ETN supplements that, “If the value of the Index decreases, or does not increase by an amount greater than the investor fee applicable to your Securities, you will receive less than your original investment in the Securities.”

Trading Shares

Once issued, most ETNs are traded in secondary markets on recognized exchanges. Technically, these securities have the potential to trade with the same amount of liquidity as an ETF. But in reality ETN liquidity is not as reliable as the liquidity of ETFs. According to the pricing supplement of Dow Jones–AIG Commodity Index Total Return ETN, “Although we have listed the Securities on NYSE Arca, a trading market for your Securities may not exist at any time. Certain affiliates of Barclays intend to engage in limited purchase and resale transactions. If they do, however, they are not required to do so and may stop at any time. We are not required to maintain any listing of the securities on NYSE Arca or any other exchange.” Several ETNs have traded volume in excess of 1 million shares on a typical day, while others go days without any trading activity. Most ETNs seem to have a typical volume at least in the tens of thousands of shares each day.

Tax Treatment

It is still unclear how the IRS views most ETNs. The IRS has stated that currency-based ETNs are to be treated as debt instruments for tax purposes. Commodity ETNs are taxed at the same capital gains rate as the commodity futures they use are when the futures are rolled. Stock and bond ETNs, however, are still a gray area. Traditionally, zero-coupon bond holders are required to pay taxes on accrued interest in the year it accrues, even though the distribution does not occur until maturity. If the IRS concludes that ETNs are most closely related to zero-coupon bonds, the same tax treatment is likely to apply. However, most zero-coupon bonds don’t have highly variable interest rates, with the real possibility of being negative in any given year, like ETNs do.

While there have been several opinions issued by law and accounting firms related to ETNs, we have not seen a definitive statement from the IRS regarding ETNs’ tax treatment. Most prospectuses acknowledge the uncertainty surrounding the tax treatment of ETNs.

In the next article we will review how well an ETN’s price tracks its indicative value as well as discuss the investor appeal of ETNs.