The Market is Catching Up with ETNs

Two years ago I wrote at RealMoney:


David Merkel
In Bondage to Barclays plc
6/21/2006 2:41 PM EDT

Roger, there is a reason to be aware the the ETNs issued by Barclays plc are notes. (or, bonds) If Barclays went bankrupt, the value of the notes would be impaired. From my limited glance through the prospectus:

The Securities are medium-term notes that are uncollateralized debt securities and are linked to the performance of the GSCI® Total Return Index (the “Index”).

and later…

The Securities are unsecured promises of Barclays Bank PLC and are not secured debt. The Securities are riskier than ordinary unsecured debt securities. The return on the Securities is linked to the performance of the Index. Investing in the Securities is not equivalent to investing directly in Index Components or the Index itself.

and much later…

USE OF PROCEEDS

Unless otherwise indicated in the applicable pricing supplement, the net proceeds from the offering of the notes will be applied for our hedging and general corporate purposes.

In essence, a holder of the ETN has bought a senior unsecured zero coupon bond from Barclays, with an ultimate payoff based off of the return on the commodities index less 0.75%/year. But unlike a bond, there is no floor on the implied interest at zero. If commodity indexes fall, the ETN would give a negative return.

I like Barclays. I own the stock. But there is more than one risk to the ETNs: commodity price risk (of course), and Barclays plc credit risk (surprise!).

Position: long BCS, and pondering the days when I used to read structured bond prospectuses regularly…

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Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs.  Perhaps it is my background in the Equity Indexed Annuity [EIA], Variable Annuity [VA], DC pension and GIC businesses — we had all sorts of guarantees and non-guarantees floating around, so we were used to analyzing the risks.

Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed?  At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away.

Be wary of ETNs, at least to the level of asking how likely it will be for the sponsor to be in good shape when the ETNs mature.