There are a lot of investment instruments for investors to choose from when investing their money. The most common are stocks, bonds, mutual funds, and exchange-traded funds. But there are some other investment options that some investors might not be aware of. One such option is exchange-traded notes.
In this post, we are going to walk through what exchange-traded notes are and if they make sense for your investment portfolio.
What Are Exchange-Traded Notes?
Exchange-traded notes are unsecured debt securities to invest in. They are also unsubordinated debt. What does this mean for investors?
Unsecured debt is simply debt that the borrower did not have to put up collateral for. The lender reviewed the borrower’s credit history, income, etc to determine if lending them money was a wise financial decision.
Unsubordinated debt is how debt is repaid in the event a business declares bankruptcy. In this case, unsubordinated debt falls last in line behind other debt obligations.
What other features make up exchange-traded notes? Unlike traditional debt, ETNs do not pay a monthly coupon payment. The way you make money investing in an ETN is by the appreciation of the market index that the exchange-traded note is tied to.
In terms of trading, exchange-traded notes trade based on an underlying index. They also act like exchange-traded funds in that you can buy and sell them throughout the day on a major exchange, like the New York Stock Exchange.
What Are The Risks Of Exchange Traded Notes?
The biggest risks when investing in exchange-traded notes are the fact that the debt is unsecured and repayment in the event of bankruptcy comes last. By not having any collateral backing up the debt, you as an investor are relying on the bank to do its due diligence and only lend to accredited borrowers.
Another risk is not getting any coupon payments. With traditional debt, you at least earn some interest for taking the risk of investing in the company debt. With ETN’s all you have is the appreciation of the notes from trading the security.
Also with relying on the index for performance, investors could see the value at maturity of the underlying index be valued at less than what they paid for the ETN in the first place.
Finally, there is a limited secondary market for trading exchange-traded notes. This means there are not a lot of investors interested in buying and selling these notes. So if you try to sell your ETN before maturity, you might have to sell at a loss simply because there is not a lot of demand for this type of investment.
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How Are They Taxed
Since exchange-traded notes are a debt product, many investors think that they treat these instruments the same as bonds. This means income is treated as ordinary income for tax purposes and any gain or loss is a capital gain or capital loss.
This is true for the most part. But remember that exchange-traded notes do not pay interest. You only have a gain or loss based on your purchase price and the selling price. Therefore, the only tax issue with this instrument is capital gains and losses.
Why Should You Invest In Exchange-Traded Notes
Exchange-traded notes are good for those investors looking to invest in niche indexes that traditional exchange-traded funds do not cover.
Another reason to consider investing in an ETN is the tax treatment. Since no income or dividends are paid out, the investor can defer gains until the instrument is sold. This could easily be years in the future when the investor is in a lower tax bracket.
In all, exchange-traded notes are not for everyone and most investors can do just fine by investing in exchange-traded funds instead.
Now that you fully understand what exchange-traded notes are, you can make an educated decision as to whether or not they are right for your portfolio. Be sure to take into account all of the risks involved and whether or not you can get the exposure you are looking for in another type of investment.
Overall, most investors are better served by sticking to traditional instruments like Motley Fool picks, bonds, mutual funds, and exchange-traded funds.