What Is an Accelerated Return Note (ARN)?
An accelerated return note (ARN) is a short- to medium-term debt instrument which offers a potentially higher return linked to the performance of a reference index or stock.
- An accelerated return note (ARN) is a type of structured investment product (SIP) that offers a potentially higher return that is linked to the performance of a specific reference index or stock.
- The payoff of an accelerated return note (ARN) is non-traditional, meaning that the payoff does not come from the issuer's cash flow but rather the performance of one or more underlying assets.
- The total return of an accelerated return note (ARN) is usually capped and they do not offer any downside protection.
- Investors purchase accelerated return notes (ARN) when they believe that the reference index will increase in value.
- The higher returns from an accelerated return note are due to the leverage employed through the use of derivatives.
Understanding an Accelerated Return Note (ARN)
Accelerated return notes (ARNs) are a type of structured investment product (SIP), also known as a market-linked investment. Structured products are a packaged investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuances, foreign currencies, or derivatives.
Structured products are designed to facilitate highly customized risk/reward objectives. They accomplish this by taking a traditional security, such as a conventional investment-grade bond, and replacing the usual payment features with non-traditional payoffs.
Traditional payoffs include periodic coupons and final principals. Non-traditional replacements include payoffs derived not from the issuer's cash flow, but from the performance of one or more underlying assets.
An ARN generally caps the total return it will provide but typically does not offer any downside protection. It would benefit those investors who believe the reference index, or stock, will appreciate only marginally but will not decline sharply until the ARN matures.
ARNs are complex and can be risky. They are unsuitable for investors that require 100% principal repayment at maturity as in a Treasury or investment-grade bond. They are also unsuited to investors seeking an uncapped return on investment in exchange for assuming 100% downside risk.
Accelerated Return Notes (ARNs) in the Financial Markets
Accelerated return notes (ARNs) appeared in the financial markets in 2010 and were primarily offered by Merrill Lynch and Bank of America. The products were marketed with a return of 2x to 3x the reference index through leverage employed by the use of derivatives, mainly call options and futures.
The products were commonly offered with a return cap of 18% to 25% and any returns over that amount were taken by the issuer. Most of these notes expired in 2013 and are not widely available any longer, most likely due to their high risk and low liquidity.
Example of an Accelerated Return Note (ARN)
Consider an accelerated return note (ARN) that is linked to the S&P 500 and is launched when the index is at 2,000. The accelerated return note (ARN) is priced at a $100 principal amount and matures in two years.
At maturity, it offers investors an enhanced return equal to two times (2x) any positive performance in the underlying S&P 500 index. The ARN is subject to a maximum gain of 30% and the investment has exposure to 100% of any decrease in the S&P 500. The returns would vary as follows depending on the scenario when the ARN matures.
- The S&P 500 is at 2,500 in two years: The S&P has had a return of 25% while twice the S&P 500 return is 50%, and the maximum return on the ARN is 30%. An investor in the ARN would receive $130 at maturity for a 30% return.
- The S&P 500 is at 2,200 in two years: The S&P has had a return of 10%, two times of which is 20%. An investor in the ARN would receive $120 at maturity for a 20% return.
- The S&P 500 is at 1,500 in two years: The S&P has had a return of -25%. The ARN investor has exposure to 100% of a decrease in the index, so would receive $75, representing a return of -25%.