This Oil ETN Pays a 21% Yield. Most Investors Don’t Realize It’s Not an ETF.

In just a few weeks, the Iran War has triggered enormous volatility into the oil markets. With oil futures prices ranging this year between the mid $50s per barrel to over $112, the intraday volatility has made futures trading a very attractive proposition. The current US blockade of the Strait of Hormuz to compel Iran to give up its means to create nuclear weapons is preventing any exports of Iranian Oil. 

The UBS ETRACS Crude Oil Covered Call ETN (NASDAQ: USOI) is an Exchange Traded Note issued by UBS. It’s delivering a 21.08% yield at the time of this writing, but it’s often mistaken for an ETF, and that’s where the distinction can become problematic for some.

UBS ETRACS Crude Oil Covered Call ETN

USOI yields are derived from covered calls written against USO and its portfolio of crude oil, natural gas, gasoline, and other hydrocarbon futures holdings.

USOI is an ETN issued out of the UBS AG London Branch. It is a note issued in April, 2017 that is set to mature in April 2037. Its portfolio holds shares in United States Oil Fund, LP (NYSE: USO), which invests in futures contracts of crude oil, natural gas, gasoline, and other hydrocarbons. USOI owns shares of USO and generates its 21.08% yield via writing covered calls against its USO positions. An overview of USOI is below:

While the monthly payout of 21% APY is very attractive to income investors, the covered call strategy caps monthly upside potential. This will result in USOI lagging behind USO, which will more fully realize gains from escalating oil prices. Conversely, once the Iran War hostilities have ended and the Strait of Hormuz is reopened, the price of oil will once again trade in a narrow range. This means that volatile will shrink, and the dividends from the covered calls will diminish proportionately. 

Additionally, despite the mystique and reputation of Swiss Bank invulnerability, UBS is in a financially precarious situation. Its acquisition of rival Credit Suisse has ballooned its balance sheet to roughly $1.7 trillion. This is nearly double that of the entire GDP of Switzerland. Basel III compliance now requires UBS to keep even higher reserves. While it’s in a better financial state than some of its current competitors in the global banking arena, UBS does have a higher credit default profile now than it might have had back when USOI was issued. 

ETF and ETN – Two Very Different Animals

ETNs and ETFs trade on similar exchanges but contain a number of stark differences, which can often be overlooked by casual investors.

Thanks to online trading, investments, trading, and buy/sell orders for securities have become just a click away. However, this has been accompanied by a deluge of information, not all of it easily digestible for the financial non-professionals. One of the pitfalls that casual investors can sometimes find themselves confused by are the proliferation of Exchange Traded Funds (ETF)  that are now publicly traded, and how they might easily be mistaken with Exchange Traded Notes (ETN). 

With an ETF, the fund itself owns the underlying assets, whether they be a basket of stocks, physical commodities (like precious metals), bonds, or even collections of derivatives. However, an ETN is in itself a debt instrument, issued by a bank. A summary of their differences are:

Structure: ETFs represent actual ownership shares in the ETF’s pool of assets, just like with a mutual fund or closed end fund. The ETN is a collection of unsecured debt notes – essentially, they are I.O.U.s of the issuing bank.

Security Risk and Recourse: As the ETF constitutes actual ownership in the underlying assets, there is pro-rated recourse available for ETF shareholders if the ETF were to go out of business. With an ETN, it is unsecured debt, so if the issuing bank were to go bankrupt, the ETN holder’s shares can possibly shrink to zero.

Liquidity: The popularity of ETFs and the fact that many of them track a specific index makes them often highly liquid. ETNs, on the other hand, are far less ubiquitous, and may expose investors to liquidity risk.

Taxation: Similar to stocks, ETFs are taxed on dividends and capital gains every year. With ETNs, taxation is deferred until the notes are sold or until they reach maturity.