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Exchange Traded Notes: A Potential Rule-Breaker?

Contributed by mm | November 12, 2007 10:05 PM PST

ipath.jpg

Both SmartMoney and Kiplinger's Personal Finance recently shed light on a completely new genre of investment vehicle available to the general investors: Exchange-Traded Notes (ETN).

iPath ETN, created and marketed by Barclays Bank, PLC, is very similar to ETF, or Exchange-Traded Funds (also pioneered by Barclays), which can be traded like a stock throughout the day, but also mimics the returns of a benchmark index. However, ETN comes with an important tax advantage over ETFs and mutual funds -- it is not required to distribute dividends and capital gains every year, making it possible for investors to avoid paying tax on such distributions, and having more money at work until the final redemption.

Now here is the caveat: in order to achieve these tax benefits, ETNs are structured as unsecured, unsubordinated debt securities issued by Barclays Bank PLC, with returns linked to a pre-defined benchmark index, minus fees. In other words, the value ETNs are secured by the credibility of Barclays instead of a pool of underlying investments.

Kiplinger's article summarized the two potential lowlights of our new vehicle:

What's the downside of ETNs? The Internal Revenue Service has not weighed in on the proposed tax treatment, so some uncertainty remains. In addition, ETN investors could suffer if Barclays's ability to repay the bonds ever came into question. That's unlikely -- Barclays is one of the world's biggest financial institutions -- but you can't dismiss the prospect entirely.

I'm not going to discount Barclays' credit risk, but let's all admit it is quite small. On the tax front, Barclays has received external counsel opinion from Sullivan & Cromwell LLP that concluded the favorable tax treatment of ETNs. Although not yet confirmed by IRS, Barclays mentioned that similarly structured products in the past issued by other companies have provided similar tax disclosure.

If its preferred tax status is confirmed (which is still an open question), ETNs can be really earth-shattering. The key is without the annual taxing on regular distributions to prevent the compounding to work on its full throttle, investors will always be better off investing in ETNs than in other index funds targetting the same benchmark.

Unfortunately, Barclays' ETN line-up currently only covers a number of commodity and currency indices, the India index and a nice covered-call strategy. If Barclays can expand its ETN offerings to major indices, many wonderful things can happen to shrewd retirement investors.

This Post Has Received 2 Comments. Share Your Opinions Too.


juan22 Commented on November 13, 2007

Very interesting article. I really did not know that much about ETN's before.


StockGuy Commented on November 22, 2007

Actually I don't think this is a very good solution. The only investors interested in a tax deferred products are those who are in high tax brackets. Why would a high income individual want to trade Dividend Tax (15%)for a deferred Income Tax (35%)?


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