Barclays Bank (NYSE:BCS) expanded its lineup of exchange-traded notes [ETNs] yesterday with the launch of three currency-focused products:
In each case, the notes provide exposure to the named currency pair: euros, British pounds and Japanese yen, respectively, against the U.S. dollar. The notes earn interest income based on the prevailing rates in the foreign country, minus 0.25 percent (see rate details below).
Investors will be quick to compare these ETNs to the popular CurrencyShares ETFs, as, for each iPath ETN, there is a corresponding CurrencyShares ETF:
The two products provide similar exposure, but come with important differences that merit close attention.
ETNs are senior, unsubordinated debt from Barclays Bank PLC. Unlike ETFs, the notes do not represent a share of assets; they are a promise from Barclays to pay you an amount reflecting any change in the underlying index. In the case of the currency notes, that means the change in the exchange rate plus any interest income.
As with any debt, the ETNs carry the risk that Barclays could default. That’s a tiny risk, of course, but it is possible; it only took one rogue trader to sink Barings Bank, which had operated for 235 years and had helped finance the Louisiana Purchase.
CurrencyShares, in contrast, own the actual asset. When you buy the CurrencyShares Euro Trust (NYSE: FXE), for instance, you buy a share in a bunch of euros sitting in a bank in London.
Both the CurrencyShares and the iPath ETNs charge 40 basis points in expenses (0.40 percent).
The two types of products pay very similar interest rates, with a slight edge to the iPath notes. These are rates as of May 8, 2007.
The CurrencyShares pay out monthly dividend interest. The iPath notes do not; instead, interest income is incorporated into the total return of the note.
The key selling point of the iPath notes is that they may be significantly more tax efficient than the CurrencyShares.
For one, the ETNs do not pay dividends -- any interest income is incorporated into the price of the note. In contrast, the CurrencyShares pay monthly dividends that are subject to taxation as ordinary income. Some investors may want this monthly payout, but the tax issue will reduce its value.
More importantly, the notes appear to have an advantage when it comes to long-term gains as well. Barclays has received an opinion that is “reasonable” to account for its ETNs as pre-paid contracts with respect to their indexes. (Note: To qualify, investors must take two steps when they buy the funds: see www.iPathETN.com). If that opinion holds, noteholders would not have to pay any taxes until they sold or redeemed the notes; even then, gains would be subject to long-term capital gains tax rates, which max out at 15 percent.
In contrast, any and all gains on CurrencyShares ETFs are subject to ordinary income taxes, which top out at 35 percent. (The IRS considers any and all currency gains as ordinary income, not as "capital gains.") So, if you buy a CurrencyShares at $50/share and sell it at $60/share two years later, you have to treat that $10 gain as ordinary income.
The difference - taxes of 15 percent vs. taxes of 35 percent - is substantial. By sidestepping the IRS rule on currency gains, the ETNs make this a much more attractive asset class.
But … and this is where it gets controversial … some people believe that the Barclays tax decision is aggressive. The Barclays’ tax statement calls this treatment “reasonable,” but in tax accounting circles, “reasonable” does not necessarily mean “true.” There is some risk in treating the gains as long-term capital gains.
One final note is liquidity: the CurrencyShares are established products with established liquidity and daily creation/redemption activity, while the iPath notes have no trading track record and only weekly creation/redemption activity. For a large shareholder, that could be a significant issue.
Which Is Better?
Which is better? That depends. The CurrrencyShares have a number of things in their favor: tax certainty, dividend payouts, no default risk and real liquidity. The iPath notes, however, have a potentially significant tax benefit, which could outweigh the other challenges for some investors. Ultimately, there’s probably room for both.