ETNs: Useful, but Watch Out for Counter Party Risk

Unlike ETFs, CEFs and mutual funds, ETNs are debt instruments subject to risk of default by the issuer as counter party. In the long term, investors need a credit risk metric for ETNs.

ETNs are a solution to the problem of difficult access to investments or to costly portfolio construction or maintenance. Because they are debt instruments indexed to an index of something else, there area no portfolios in the ETNs and there is no tracking error, except to the extent of contractual management fees or (if any) contractual offsets from the index being tracked.

Examples of the type of investing difficulties ETNs solve include certain restricted emerging markets, such as India, and investing in commodities, such as oil, grains, and metals. In the future, there could be ETNs based on more esoteric indices. Only time will tell. There is no effective limit on what can be used to index the principal value of an ETN.

On the other hand, ETNs introduce counter party risk.

The ETN issuer assumes the risk that they can offset their liabilities under the ETNs by whatever internal mechanisms they chose, but if the issuer becomes insolvent for any reason, including reasons having nothing to do with the ETNs, the ETN holders will become general creditors in the bankruptcy court.

The risk of that problem becoming a practical reality is probably low now and probably will remain low, but the risk is not zero.

How great is the risk? How does the risk change from period to period? As new ETN issuers enter the market, how does the risk vary by issuer? Who is in a position to evaluate the risk? We presume organizations such as Standard & Poor’s or Moody’s will take up the torch and eventually launch some sort of metric if the ETN sector grows.

It is probably possible now for a sophisticated credit analyst to interpret credit ratings for the bank issuers in terms of risks for ETNs, but the retail investor needs a single source for ETN key data, including credit risk, and that data must be reasonably easy to understand.

In any event, an informed investor should understand that ETNs involve credit risk. That risk is not now well publicized and is probably currently minimally understood.

Just be careful and do not overload with ETN credit risk until more useful information become available.

Comments

[vensh]

An interesting article, but exactly HOW are ETNs useful for investing in commodities where many existing products offer no issuer risk? (ETFs and mutual funds!)