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What to Know About ELNs in a Banking Crisis

The banking crisis that has now claimed Credit Suisse has everyone evaluating bank-related risks across ETF portfolios.

It’s a no-brainer that ETFs accessing financials and related segments to varying degrees are faced with risks associated with this crisis. It’s also pretty obvious that exchange-traded notes (ETNs) are in the line of fire as unsecured debt notes issued by financial institutions, aka banks. Credit Suisse itself is estimated to be behind some $700 million in ETNs.  

However, one less-obvious place where bank-related risks may lurk is among structured notes used in ETFs, specifically equity-linked notes (ELNs.)

ELNs are a type of structured product that brings together a debt security with an equity options component, designed to offer investors some level of principal preservation, some income generation, and some participation in the returns of the underlying equity. Typically, the payoff of a product like an ELN is either growth or income.    

As a structure, ELNs aren’t that widely used within ETF portfolios, but we’ve seen them peppered in some hugely popular funds, like the J.P. Morgan Equity Premium Income ETF (JEPI) and its Nasdaq-linked counterpart, the J.P Morgan Nasdaq Equity Premium ETF (JEPQ).

These ETFs, which invest in large cap equities and sell S&P 500 or Nasdaq 100 call options (respectively), wrap the options in ELNs in an effort to capture options premium as dividend income. (We recently looked into how JEPI works here.)

In the context of a banking crisis, it’s important to remember that ELNs are debt notes issued by banks, which means ETFs that use ELNs face credit risk associated with the banks issuing these notes.

Is it a meaningful risk?

In truth, it depends. In the case of JEPI, for example, the $21.5 billion Fund showed in its last semi-annual report (as of Dec. 31, 2022) that it had a 15.3% allocation to ELNs. (Image below). For context, that position is below the Fund’s cap, as detailed in its prospectus, where ELNs are limited to no more than 20% of the portfolio at any time.

A closer look at the top 10 holdings in JEPI as of Dec. 31, 2022, shows that a bank such as Credit Suisse is notably absent from the mix, according to the report. In fact, there are no ELNs among top holdings:

But that’s not always the case. Just six months earlier in the previous annual report dated June 30, 2022, Credit Suisse ELNs were among top positions totaling 3.2% of the fund’s portfolio, along with notes from Canadian Imperial Bank of Commerce as well as Societe Generale. (Image below)

JEPI’s Nasdaq counterpart, JEPQ, tells a similar story. JEPQ, which has about $2 billion in assets, had ELNs representing about 17.3% of the portfolio mix as of Dec. 31, 2022, according to the semi-annual report, but no Credit Suisse ELNs to be found in the top bracket. UBS, however, sat there with a 4.6% position, followed by Citigroup, Bank of America and BNP Paribas. (Image below)

Structured notes are big business to banks, which take into account many factors such as balance sheet and market conditions when pricing and issuing these products, but the changing mix of issuers across JEPI and JEPQ tells us that fund managers aren’t limited to a single bank for its ELNs. They have a choice and that choice can change at any time.     

So, Should You Worry About ELNs?

Broadly speaking, if you invest in an ETF that includes ELNs, you are exposed to credit risk associated with the bank issuing those debt notes. However, there are other things to consider.

First, your exposure is limited by regulatory design. The Securities and Exchange Commission Rule 12d3-1 of the Investment Act of 1940 caps single issuer risk to 5% of ETF portfolios, which in the case of exposure to an issuing bank behind ELNs means that position – exposure to that bank – can’t exceed 5%. And remember that in the case of JEPI and JEPQ, the fund’s prospectuses further cap ELN weightings at 20%.

Second, position size matters, but so does term. How long until the ELNs in the portfolio hit maturity? You could argue that in the case of a market event such as a banking crisis, the shorter-term the ELN is the more easily it can be unwound early or allowed to simply expire without much effect vs. a longer-term position – say one year to maturity or longer. Do you know the average term of an ELN in your ETF?   

Third, there’s the issue of liquidity of the underlying. If you take JEPI as an example, the S&P 500 options market is a deep $1 Trillion market, with ample liquidity, making transacting across the ELNs easy to do in the secondary market. Consider that through Friday, March 17, as news of Credit Suisse’s troubles swirled and concerns about a banking crisis deepened, JEPI’s 30-day median bid/ask spread remained at a tight 0.02%, data shows.  

And finally, you could argue a banking crisis is a prime opportunity to get to know your ETF’s investment approach. If your fund is run by an active manager, do you know the rules they follow and their expertise in the space? It’s in times like these that experience with everything from security/partner due diligence to position management to portfolio structuring and trading that can make a big difference in overall results. As you fret about a global banking crisis, do you actually know your active manager, or how your ETF is managed day to day? 

ELNs or no ELNs, it’s always a good time to know what you own.


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