Should Income-Starved Investors Consider ETNs?

By John Whitefoot

While quantitative easing (QE) may have been put in place to kick-start the economy, it also had the added benefit of kicking income investors to the curb. Since implementing QE1 in November 2008, the Federal Reserve has printed over $3.0 trillion to snap up government bonds.

This has translated into artificially low interest rates, which are supposed to spur borrowing. A low-interest-rate environment has also helped fuel the stock market and put a smoldering spark in the housing market and auto industry. Those same record-low interest rates have also sucked the income out of America’s retirement portfolio.

In a high-interest environment, fixed income assets like Treasuries, bonds, and certificates of deposit are an important part of most retirement portfolios. In theory, they provide regular investors with a stable place to park their retirement money and a means to anticipate a reliable income stream.

In 1980, Treasury bonds peaked at an eye-watering 14%. Today, a 30-year Treasury bond provides a yield of just 3.67%, a far cry from 1980 and a long way from the 5.3% yield in late 2007—before the financial crisis began.

In order to diversify risk, invest in multiple asset classes, and take advantage of growing dividend yields, many investors have turned to exchange-traded funds (ETFs). ETFs are a great option for broad-based investing; especially for those who do not have deep pockets. In fact, with a simple ETF strategy, investors can build a well-diversified portfolio made up of small-, medium-, and large-cap stocks.

While ETFs continue to grow in popularity, investors looking for more options might want to consider exchange-traded notes (ETNs). On the surface, ETNs are similar to ETFs in that they track an underlying index or asset class, such as commodities (energy, grains, livestock, industrial metals, petroleum), foreign currencies (yen, euro), and equities.

ETNs are similar to ETFs in that they are listed on an exchange and can be bought and sold throughout the trading day. One major difference is that an ETN, being similar to a bond, is subject to the financial strength of the backing institution.

A change in the providers’ financial situation could have a detrimental impact on the value of the ETN, regardless of how the underlying index is performing. Some of the institutions that issue ETNs include Morgan Stanley MS, Barclays PLC BCS, Credit Suisse Group AG CS, The Goldman Sachs Group, Inc. GS, and UBS AG UBS.

If an ETF provider went out of business, investors would still have a claim on the funds’ underlying securities or the market value of those securities. Whereas ETFs are subject to market risks, ETNs are subject to the lender’s underlying credit worthiness.

Not surprisingly, ETNs aren’t for everybody. Cautious investors who don’t like the idea of assuming the credit risk and potential loss of their investment, no matter how remote the possibility might be, might want to avoid investing in ETNs.

Why would anyone want to consider adding an ETN to their portfolio? ETNs are gaining popularity mainly due to the advantages that they offer to investors. For starters, ETNs track the underlying product/index exactly, while ETFs simply try and replicate the performance of the underlying index.

ETFs also have to make yearly capital gains and required income payments to shareholders, which are taxable. ETNs do not have to make these distributions; as a result, investors can defer taxes until the ETN is sold or it matures.

In a nutshell, an ETF is like a stock and an ETN is like a bond. If you’re comfortable with the institution providing the ETN, you can take advantage of these many benefits not found in an ETF.

This article Should Income-Starved Investors Consider ETNs? was originally published at Daily Gains Letter