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.