One of the largest players in the U.S. exchange-traded note marketplace is in deep trouble, calling into question the billions of dollars invested in ETNs.
Deutsche Bank, sponsor of the DB notes, was recently smacked with a proposed $14 billion fine by the U.S. Justice Department related to the bank’s mortgage-backed securities practices leading up to the financial crisis. The company, which was founded in 1870, has seen its publicly traded shares crash more than 57% over the past two years.
After suspending issuance of new DB ETN shares on Jan. 1, 2016, Deutsche Bank has since retracted from its foothold in the ETN business.
On September 20, the company redeemed eight ETNs, including the DB 3x Long 25+ Year Treasury Bond ETN (LBND) and DB 3x Short 25+ Year Treasury Bond ETN (SBND), along with notes linked to government bonds from Germany and Japan.
Although Deutsche Bank’s problems have widespread ramifications for the financial advisors and investors who use ETN products, there’s still a lot of complacency surrounding these vehicles. While ETN assets represent just 1% of the total U.S. market for exchange-traded products, including exchange-traded funds, they still have amassed $23.7 billion in assets. In other words, there’s still a lot of money invested in ETNs, despite the peril surrounding one of its biggest players.
Let’s examine a few spooky truths about ETNs.
1. ETNs contain more than just market risk.
ETNs, unlike their ETF cousins, are unsecured debt instruments that pay a return linked to the performance of an index, a currency or a single commodity. Similar to bonds, ETN payments rely on the full credit and faith of the entity backing the product.
Eric Balchunas, author of The Institutional ETF Toolbox: How Institutions Can Understand and Utilize the Fast-Growing World of ETFs, estimates that 80% of the $23.7 billion invested in ETNs is parked in products tied to master limited partnerships and volatility.
The value of ETNs is largely determined by the performance of their underlying index or asset and the creditworthiness of the issuer. What does it mean? If the bank or issuer backing the ETN stops issuing new shares in the notes they sponsor, distortions in the ETN’s share price and the underlying value of its assets are likely to compound. Even worse, if the ETN sponsor goes belly up as Lehman Brothers did in 2008, ETN shareholders can lose all of their money.
2. The tax-advantages of ETNs are uncertain.
Although ETNs are touted for their tax efficiency over mutual funds and ETFs, how they are taxed is far more complicated and uncertain. For example, commodity-linked ETNs are taxed at the same capital gains rate as the commodity futures they use when the futures contracts they own are rolled. On the other hand, commodity ETNs that invest in physically backed precious metals would have a maximum long-term capital gains tax rate of 20% compared to 28% in a gold-back ETF. And ETNs that track currencies and equities are taxed at varying rates.
More importantly, the IRS has yet to give its official opinion about the taxation of stock and bond ETNs. Currently, these types of ETNs have no annual tax because there is no interest or dividend distributions made. A capital gain (or loss) is realized when shareholders sell their notes or hold them to maturity.
Most prospectuses acknowledge the uncertainty surrounding the tax treatment of ETNs, but how much damage would a negative tax ruling by the IRS have on ETN shareholders?
3. The history of ETNs as long-term investment products isn’t very promising.
The failure of the Lehman Opta ETNs raises serious doubts about the viability of ETNs should backers encounter financial problems. While many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years, the viability of an ETN sponsor can quickly change for the worse.
While well-known ETN sponsors such as Barclays, JPMorgan Chase and UBS don’t appear to be in a crisis like Deutsche Bank, advisors should error on the side of caution. Moreover, many of the specialized asset classes that ETNs exclusively covered in the past are now offered in an ETF wrapper.
Before buying ETNs, advisors should do their due diligence to check for an ETF alternative that offers market exposure to the same asset class. The latter choice may have slightly higher tax consequences and tracking error, but these disadvantages may be offset by the significant credit and taxation risks of ETNs.
To put it another way, investors should approach ETNs with caution.
Ron DeLegge is founder and chief portfolio strategist at ETFguide.