Exchange-traded Notes (ETNs) are senior, unsecured, unsubordinated debt securities that provide investors with exposure to the total returns of various market indices, including those linked to stocks, bonds, commodities and/or currencies, less investor fees. ETNs must not be confused with ETFs (Exchange-traded Funds) - unlike ETFs, ETNs are bond instruments with a set maturity date that do not buy or hold assets to replicate or approximate the performance of the underlying index.
I think it is important that investors understand the concept of an ETN's indicative value and always keep track of that value in relation to the market price.
Indicative Value versus Market Price
An ETN's "indicative value" is used to measure the intrinsic value of each ETN and is calculated and published by the issuer at least once a day. However, the indicative value should be used for reference purposes only, and is not an indication of the market, redemption or termination price. It also does not reflect market liquidity, bid offer spreads, or hedging or transaction costs.
The ETN's market price is simply the price at which the ETN trades in the secondary market. In theory, an ETN's market price should closely track its indicative value. But in reality, an ETN's market price can deviate, sometimes significantly, from its indicative value. This would represent a market inefficiency, which can mean a great trading opportunity for a savvy investor.
Issuers of ETNs can issue and redeem additional notes as a means to keep the ETN's price close to the indicative value or closing indicative value for ETNs. When an ETN is trading at a premium above the indicative value, issuing more notes to the market can bring the price down. Similarly, if an ETN is trading at a discount, redemption of notes by the issuer reduces the number of notes available in the market, which tends to raise the price.
UBS AG offers an interesting array of ETNs, called ETRACS, which are the focus of this article. These ETNs are relatively new and rather thinly traded, since the average investor is not familiar with them. In addition, the fact that there is very little descriptive information to be found on sites like Yahoo and Google Finance, and not a lot of investment publications, does not make things any easier for investors. With that in mind, here are the more relevant statistics for 13 ETRACS ETNs:
- ETRACS Alerian MLP Infrastructure ETN (NYSEARCA:MLPI)
- ETRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure ETN (NYSEARCA:MLPL)
- ETRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS)
- ETRACS 2x Leveraged Long Wells Fargo Business Development Company ETN (NYSEARCA:BDCL)
- ETRACS Monthly Pay 2xLeveraged Dow Jones International Real Estate ETN (NYSEARCA:RWXL)
- ETRACS Monthly Pay 2xLeveraged Dow Jones Select Dividend Index ETN (NYSEARCA:DVYL)
- ETRACS Monthly Pay 2xLeveraged S&P Dividend ETN (NYSEARCA:SDYL)
- ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL)
- ETRACS Diversified High Income ETN (NYSEARCA:DVHI)
- ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (NYSEARCA:DVHL)
- ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA:CEFL)
- ETRACS Wells Fargo® MLP Ex-Energy ETN (NYSEARCA:FMLP)
- ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN (NYSEARCA:LMLP)
|NYSE Ticker||Market Price at end of 7/28/14||Indicative Value at end of 7/28/14||Annual Tracking Fee||Latest Payment Date||Latest Coupon Amount||Payment Schedule||Current Yield (annualized)||Maturity Date|
Note that the yield shown above is annualized based on the latest coupon payments and the ETNs' market prices on 7/22/14; it is not a prediction of the yield for the next 12 months, since the periodic payments have a variable coupon rate.
3 of the above-noted ETNs should be strongly considered for the high-yield portfolio:
First, BDCL, which tracks a 2x leveraged investment in the Wells Fargo Business Development Company Index (WFBDC). The Index value bottomed out in mid-May and has already rebounded. I currently own BDCL mainly because of its high yield, exposure to the Business Development Companies , and diversification across the BDC sector. I don't buy individual BDC stocks much anymore, except when stock prices dip well below net asset value after the occasional market overreaction to some bad news.
Key points for BDCL:
- Current share price: $27.09
- The 52 week range is $24.11 to $30.61
- Earnings estimates for 2014: N/A
- Annual Yield: 13.89%, but constantly variable
- Top 3 Holdings in Underlying Index: Apollo Investment Corp (NASDAQ:AINV), American Capital Ltd (NASDAQ:ACAS), Prospect Capital Corp (NASDAQ:PSEC)
An even more interesting choice is the newcomer DVHL - the 2x Leveraged Diversified High Income ETN. This Note presents incredible diversification, monthly coupon payments, and the tracking fee is the same as that for BDCL. Its underlying index is the NYSE Diversified High Income Index, which includes a diversified basket of 138 publicly-traded securities that historically pay significant distributions. The index is rebalanced quarterly to maintain the target weightings as shown below:
DVHL Asset Class Weightings:
Key points for DVHL:
- Current share price: $28.41
- The 52 week range is $23.07 to $31
- Earnings estimates for 2014: N/A
- Annual Yield: approx.12.57%
- Top 3 Holdings in Underlying Index: Powershares Emerging Markets Sovereign Debt ETF (NYSEARCA:PCY), iShares High Yield Corporate Bond ETF (NYSEARCA:HYG), iShares Preferred Stock ETF (NYSEARCA:PFF)
Thirdly, MORL is probably the riskiest and most controversial of the ETRACS ETN. But with the high risk usually comes a high reward which is reflected in that head-spinning a 18.9% yield. It offers monthly compounded 2x leveraged exposure to the Market Vectors Global Mortgage REITs Index, less fees. It is the only exchange-traded product with leveraged exposure to a mortgage REIT index offered on U.S. exchanges.
The top 3 components of MORL's underlying index are Annaly Capital Management (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), and Chimera Investment Corp. (NYSE:CIM). Based on the volatility of the mREITs in the underlying index, and the added risk of rising interest rates in 2015 to more normalized levels, MORL is not a great choice for the average investor. However, it can be a useful tool for investors who want exposure to mREITs and who understand and can accept the added risks that are inherent here.
The risk that is specific to ETNs is the issuer credit risk, which is the potential that the issuer may default on the note or take other actions that may impact the price of the ETN. An ETN investor must be aware of the issuer's credit rating. For example, the credit rating for UBS AG is Aa (Moody's); A (S&P); A (Fitch). Moody's credit rating scale is: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, with WR and NR as withdrawn and not rated. Standard & Poor's and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, D.
Simply put, ETNs can offer investors convenient and cost-effective way to diversification and high yield. It is really an indirect way to diversification since, as I mentioned, the ETN does not hold any assets, but because the underlying index often tracks a wide variety of securities. ETNs can be complex and can carry numerous risks, such as market risk, liquidity risk, redemption risk, and of course the issuer credit risk. However, the income potential can be very significant, especially from leveraged ETNs whose high coupon payments are realized as the dividend payment of the underlying index gets multiplied by the leverage factor of the ETN.
Disclosure: The author is long BDCL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.