With last week's banking woes and especially the weekend fire sale of Credit Suisse (CS) to UBS Group (UBS) , let's look at a small but interesting corner of the exchange-traded product (ETP) universe, the exchange-traded note (ETN).
ETNs represent about $10 billion of the roughly $7 trillion invested in ETPs in the U.S. or about 0.14% of invested assets. Still, they provide an opportunity for investors to access exposures they otherwise would not be able to access (although that has been changing over time) and also provide multiple income streams for the banks that issue these products. Let me explain.
What Is an ETN?
ETNs, in the strictest capital-markets speak, are pieces of subordinated debt. This debt is issued by banks that provide holders an income stream based on the return of some underlying asset. There are currently 83 ETNs available from six issuers. Among these issuers are the biggest by numbers: UBS/Credit Suisse (33); Barclays/iPath (25); and MicroSectors (19) issued by the Bank of Montreal (BMO) . Those account for 93% of the total issuance. From an assets under management perspective, products are concentrated with the largest, the $2.5 Billion J.P. Morgan Alerian MLP Index ETN (AMJ) , followed by the next two at $1.1 billion, MicroSectors U.S. Big Oil Index 3X Leveraged ETN (NRGU) and MicroSectors FANG+ Index 3X Leveraged ETN (FNGU) and the rest ranging from $860,000 to $684 million.
The underlying asset is where things can get interesting. If you want exposure to physical commodities, carbon certificates, volatility, leveraged income, and equity factors like quality, size, and value? You've come to the right place. It used to be that ETNs were the only place to get access to most of these types of asset classes and exposures, but since rule changes approved in 2019 by the SEC, the use of leverage and swaps have become more commonplace in the ETF structure, and we have seen an increase in what used to be considered too exotic for ETF type exposures.
What's in It for the Issuing Bank?
When you look at the ecosystem for ETFs, you see a lot of players, including fund administrators, custodians, sub-advisors, swap counterparties, market makers, not to mention lawyers. Each of these provided services ends up being a line item on the expense side of a fund's income statement in the annual report. What also creates an expense of sorts are trading costs and other frictions involved in running a fund. These may not be explicitly described in a fund's marketing material, but they will show up in the annual report.
Banks like ETNs, because, while an ETF issuer has to write checks to all its service providers, ETN issuers can internalize virtually all those costs. Internal groups that handle debt origination bring the ETN to market, the swap desk manages the product while trading hedges the bank exposure. ETNs are brought to market as a kind of shelf offering, meaning the overall deal size will be so many hundreds of millions of dollars, and new investors will have shares delivered from within the bank, so there is no need for Authorized Participants or other capital markets players. Most of the time, the bank will also act as its own market maker, providing another revenue stream.
To be clear, I'm not knocking banks for being able to internalize these revenue streams but, the more you know, you know?
About That Subordinated Debt
For those not familiar with corporate debt structures, there is a pecking order when and if it comes time to dissolve or unwind any company -- banks included. Secured debt holders get paid back first, then senior unsecured debt holders, then subordinated debt holders, and finally, preferred equity, regular equity, and rights and warrant holders. The bottom line here is that unless you hold one of the first two types of debt mentioned, you, in the immortal words of Willy Wonka, "Get Nothing!"
We saw this in 2008 when Lehman Brothers went bust and there was real concern that Credit Suisse ETN holders would also be wiped out. With the rescue by UBS, it doesn't look like this is going to happen. Still, an additional and potentially disastrous risk in holding an ETN is the credit risk of the issuer. Remember, ETF underlying holdings are held by a custodian and if an ETF issuer goes under, those shareholder assets are liquidated and returned to shareholders. An ETN is a line item on a bank's balance sheet and carries as much risk as any other item on the bank's books.
Wrap It Up
If you look at the history of ETN issuance in the U.S., there have been a total of 314 ETNs brought to market with 213 shuttered since launch. Further, 67 of the 83 remaining ETNs have less than $100 million in assets. The bottom line here is that ETNs can provide some unique exposures to investors. They tend to be more expensive than the ETF versions and there is the added wrinkle of investors needing to understand and appreciate the credit quality of the issuer and any risks associated with that rating. If you can get comfortable with an issuer's credit quality rating and know that you want the exposure a particular ETN is providing, then don't let me stop you from dropping that ticket.
