The stunning collapse of major financial institutions like Bear Stearns and Lehman Brothers Holdings has heightened the scrutiny of obscure financial products issued by these companies – including investments called exchange-traded notes or ETNs.
ETNs are unsecured debt instruments that pay a return linked to the performance of an index, a currency or a commodity. In a similar arrangement to investing in bonds, ETN payments rely on the full credit and faith of the institution backing the product. Many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years.
The iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP), the iPath S&P GSCI Total Return Index ETN (GSP), and the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL) are among the most popular notes.
Other ETNs track leveraged benchmarks, such as the PowerShares DB Gold Double Short ETN (DZZ), the PowerShares DB Crude Oil Double Short ETN (DTO), and the PowerShares DB Agriculture Double Short ETN (AGA).
While major ETN sponsors like Barclays PLC (BCS) and Deutsche Bank AG (DB) appear to be financially sound at the moment, solid credit ratings are far from guaranteed.
Lehman ETNs, launched seven months ago, never delivered on their promise, and note holders are waiting to get their money back.
What lessons can be learned? For many investors looking to reduce their financial risks, ETNs fell short. Along with market risk, ETN investors bear credit risk. As the Lehman ETN blowup illustrates, if the company backing the products goes out of business, ETN investors are left in the lurch.
Thus, it may be best for advisors to keep clients’ portfolios simple. And stick with broadly diversified index mutual funds and ETFs.