The turmoil in financial and credit markets the past few years has put a focus on the credit risks of exchange traded notes. However, the creation and redemption feature of ETNs moderates some of the risks, analysts say.
ETNs are debt instruments issued by financial institutions that promise to provide the return of an index, minus taxes and fees. Exchange traded funds, on the other hand, represent a share of an underlying portfolio of securities.
The main credit risk of an ETN is that the issuer goes belly up.
“A topic that is often highlighted regarding ETNs is the credit risk associated with the issuer and any potential impact it may have on its price performance relative to its underlying index,” Wells Fargo analysts wrote in a recent report. “Although the ETN carries the credit risk of its issuer, we believe its redemption mechanism, when working properly, significantly reduces the duration of this risk.”
The ETN business is relatively small with $14 billion in assets compared with $952 billion for ETFs at the end of September. Within ETNs, Barclays accounts for 51% of the assets, and 80% of assets are in ETNs issued by only three issuers, according to Wells Fargo.
Shares of ETFs and ETNs can be created or redeemed in large blocks by so-called authorized participants, usually financial institutions. This feature enables the “arbitrage mechanism” that keeps the price of a share in line with the net asset value. [What is an ETF? – Premiums and Discounts]
“However, unlike the majority of ETFs, instead of using the physical underlying assets, ETNs create and redeem with their cash equivalents,” Wells Fargo notes. “Similar to ETFs, the creation/redemption process helps keep the price of ETN shares close to their indicative value. However, almost equally important, it allows market participants to redeem their holdings at the indicative value, usually on short notice (typically no more than 10 days). Accordingly, even though the maturity of an ETN may be as long as 30 years, the daily redemption feature allows for significant reduction of the duration of credit risk exposure to days instead of decades.”
The analysts concluded: “A full default would have to occur almost without warning for ETN investors to face serious risks to their principal as a result of the issuer’s credit risk.”