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Exchange-Traded Notes—CNBC Explains

Exchange-traded notes, or ETN's, are a relatively new type of investment, but growing in popularity. So what are they and how do the work? CNBC explains.

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What are ETNs?

They are an unsecured debt security, usually issued by an investment bank. It's important to note they are unsecured and not guaranteed by the issuer.

Financial institutions like JP Morgan Chase, UBS, and Barclays offer ETNs. In fact, Barclays was the first to ever offer ETNs in 2006.

The purpose of ETNs is to create a type of security that combines both the aspects of bonds and exchange-traded funds (ETF). But ETNs do not have stocks or any other equity product.

ETNs have had names like BOXES, LUNARS, MITTS, PERQS, and PISTONS, to identify them.

What is an ETF?

An ETF is a security that tracks an index, a commodity, or assets such as an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. For a fuller description of ETFs, check out the CNBC explains.

What are the similarities and differences between ETFs and ETNs?

Like ETFs, ETNs are traded on major exchanges, such as the New York Stock Exchange, during normal trading hours. Like ETFs, ETNs can be bought and sold during normal trading hours on the exchanges.

When you buy an ETF, you're buying a slice of a diversified portfolio of stocks. But when you buy an ETN, you're buying a promise of a debt payoff — specifically, the promise that the issuer will pay the note according to the terms laid out in the ETN's prospectus.

The promise is just that — a promise. As mentioned above, there's no guarantee of payment and no current regulation forcing one.

Investors can hold the debt security until maturity. At that time, the issuer will give the investor a cash amount that would be equal to principal amount — minus any related fees and commissions.

Unlike ETFs, holders of ETNs pay no interest or dividend distribution, which means there is no annual tax. Capital gains — or losses are realized when an investor sells the ETN, or when it matures.

One factor that affects an ETN's value is the credit rating of the issuer. The value of the ETN may drop despite no change in its underlying asset. That drop in value would come from a downgrade in the issuer's credit rating.

What's an example of an ETN not paying off?

One only has to look at the collpase of Lehman Brothers in September 2008. Lehman's ETNs — which were marketed for less than a year — had little in the way of assets beyond their seed capital.

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