exchange traded notes: structure and counterparty risk

In short

A friend of mine once showed me his brokerage screen and asked why his "fund" had gone to zero overnight. It was not a fund at all. If you are holding an exchange traded note, you hold a loan to a bank, and the bank's health matters as much as the index the note follows. Read the prospectus to find out who issued the note. Look up that issuer's credit rating, and ask whether you would lend that bank money directly. Check the note's fees and its maturity date. Learn how the note's value is calculated each day. Short answer, know your borrower.

The whole of it

What it is

I once watched a neighbor sign a paper at the bank and walk away thinking he had bought a piece of something. What he had really done was lend the bank a little money. An exchange traded note works much the same way. It is a debt security, sold by a bank or other financial company, that trades on a stock exchange like a share. The issuer promises to pay the holder an amount tied to an index or a strategy, minus fees, on a set date.

An exchange traded fund is a different animal. A fund holds real assets, such as stocks or bonds, in a pool owned for the benefit of its investors. A note holds no pool for you. The note is an unsecured promise, which means nothing has been set aside to back it. If the issuer fails, the note holder stands in line with other unsecured creditors.

I will say it plainly, because it is easy to miss. The note can look just like a fund on a screen. It has a ticker symbol. It has a price that moves all day. It may follow the same index as a fund you know well. The difference sits in the legal structure, and that is where the risk hides.

How it works

If you have ever lent a friend $100 and been promised $105 back in a year, you already understand the bones of it. The issuer sells the note and gets the cash. In return, the issuer promises a payoff linked to some measure, such as a stock index or the price of a commodity. Some notes pay no regular interest, and some do. The prospectus, which is the legal document that describes the note, spells out which kind it is.

The note has a maturity date, the day the issuer agrees to pay. The maturity date can be many years away, and the prospectus gives the exact date. Along the way the note trades on the exchange, so a holder can usually sell to another buyer before maturity. The price a buyer will pay depends on two things. One is how the index has done. The other is how safe the market thinks the issuer is.

Here is a quiet point that surprises people. The note's price can fall even when the index does fine, if the issuer's credit worsens. Buyers want less for a promise from a shakier borrower. So a holder carries two risks at once, the market risk of the index and the credit risk of the issuer.

Most notes also carry an investor fee, charged against the note's value each year. Some can be redeemed early by the holder in large blocks, at a price set by a formula. Some can be called, meaning the issuer has the right to end the note early. The prospectus says which features apply, and the holder is bound by them.

The numbers, and where to find yours

Every note has a few numbers worth finding. The first is the annual fee, often called the investor fee or tracking fee. The prospectus lists it as a percent. The second is the maturity date. The third is the issuer's credit rating, which comes from rating firms such as S&P Global Ratings, Moody's, and Fitch Ratings. Each publishes its own scale, and each issuer's rating is posted on that firm's website or in the issuer's own filings.

Your best source for the note itself is the prospectus, filed with the Securities and Exchange Commission. You can search the SEC's EDGAR database by the issuer's name or the note's ticker. Look for the pricing supplement and the prospectus supplement. They name the issuer, the fee, the maturity, and the risk factors in the issuer's own words.

For the credit side, the issuer's annual report on Form 10-K gives a picture of the company's finances. If the issuer is a bank, regulators set capital rules for it. The Federal Reserve and the Federal Deposit Insurance Corporation publish information about banks they oversee. Investor Bulletins from the SEC's Office of Investor Education and Advocacy also explain how these notes work, and FINRA has investor materials on them as well.

One more number matters here. The Securities Investor Protection Corporation, known as SIPC, protects customers if a brokerage firm fails and assets go missing. It does not protect against a drop in the value of a security, and it does not cover an issuer that defaults on its debt. Those are different risks. Confusing them is a common mistake.

A worked example

Let me tell you about a woman named Dolores. She is a retired schoolteacher, and she bought a note for $10,000. The note follows an index and charges a fee of 0.95 percent a year, which she found in the prospectus.

Her yearly fee is 0.95 percent of $10,000, which is $95. Over five years, if the value stayed flat, the fee alone would take about $475. That is 5 years at $95 a year. She weighed that cost against what she hoped to gain.

Now picture the index rising 20 percent over those years. On $10,000, a 20 percent gain is $2,000. Take away the $475 in fees and her payoff looks like $11,525, which is $10,000 plus $2,000 minus $475. So far, so good.

Here is the part that caught her by surprise. Suppose that in year four the issuing bank runs into deep trouble and cannot pay its debts. The index may still be up. But the note is only a promise from the bank. If the bank fails, Dolores becomes an unsecured creditor. She might get back only a part of what the note was worth, or in a bad case, very little. The index did nothing wrong. The borrower did.

Now suppose the bank stays healthy but the market grows nervous about it. The note might trade at $9,400 even though the index is up. That would be a paper loss of $600, from $10,000 down to $9,400. She would feel it only if she sold. Dolores learned that two questions have to be asked. How is the index doing, and how is the borrower doing?

Where it goes wrong

I have seen smart people trip over the very same stone. The first is thinking a note is a fund. They share a look and a ticker, so the mind fills in the rest. The second is ignoring the issuer, because the index gets all the attention in the marketing.

A third trouble is early termination. Some notes have a clause that lets the issuer end the note early under set conditions. The prospectus for such a note may say that the holder gets a payout based on a formula, which can be well below what the holder paid. A volatility note can be ended early this way after a sharp market swing, and the prospectus lists the exact triggers.

A fourth trouble is fees that eat the gain. A fee of 0.95 percent sounds small. On $10,000 it is $95 a year, and it comes out whether the index rises or falls. Fifth, a note that tracks a daily move, such as one that aims to double or invert a day's result, can drift far from the long term result. The prospectus describes this, and it is worth reading with care.

Last, a thinly traded note can be hard to sell at a fair price. The gap between what buyers bid and sellers ask can widen when markets are stressed. That is a cost too, even though no bill arrives.

Questions to answer before you leave this page

Can you name the company that issued your note, and do you know its credit rating from S&P Global Ratings, Moody's, or Fitch Ratings? Have you found the prospectus on the SEC's EDGAR database, and have you read the risk factors in it? Do you know the annual fee in dollars, such as $95 on $10,000, and not just as a percent? Do you know the maturity date, and whether the issuer can call the note early? Could you stand to see the note fall in price if the bank grows shaky, even while the index holds steady? Does your brokerage statement call this a note, a fund, or something else? And if the issuer failed tomorrow, would you be at peace with being an unsecured creditor in line for whatever is left?