Normally, you can’t expect interest or dividends from investing in gold. But this has changed, thanks to a convoluted new vehicle launched by Credit Suisse: an ETN (Exchange-Traded Note) called Gold Shares Covered Call ETN (NSDQ: GLDI).

As we’ve said before in this space, ETNs are IOUs issued by investment banks based on the returns of particular indexes. In this case, the IOU is issued on the quirky “Credit Suisse NASDAQ Gold FLOWS 103 Index.”

This Index is quirky because it doesn’t actually move with the price of gold. It is instead designed to capture up to a 3 percent gain in the price of gold each month, but it fully participates in any monthly declines.

So take note: the most you can make on this index is 3 percent a month, but you can lose say 25, 50 or 75 percent in any one month, should gold prices tank. Limited upside; unlimited downside.

Where does the income come from? Credit Suisse sells “covered call” options on a popular, gold-holding ETF (exchange-traded fund) — SPDR Gold Shares (NYSE: GLD). This ETF actually holds gold bullion.

Why covered call options? “Covered” means that Credit Suisse owns the assets, in this case shares of GLD, on which it’s selling options. For a fee, or premium, it then sells the option to buy GLD shares for a pre-determined higher price in the future.

This way, Credit Suisse protects itself should gold prices remain steady or fall, while using the premiums it collects on the covered call options to pay the GLDI shareholders a variable income.

Shining a Light on All that Glitters

The GLDI ETN is a “synthetic” investment. That means if you invest in this ETN you don’t actually own any gold or even a stake in the underlying Index. And the hypothetical returns on GLDI reveal its weaknesses.

The Credit Suisse prospectus for GLDI provides hypothetical data for a period of 4.5 years: June 3, 2008 to October 19, 2012.

Had you actually owned gold or the GLD exchange-traded fund (ETF) during this period, your total return would have been roughly 86 percent. But the total return on GLDI would have been half that amount — 41 percent. Clearly, you would have been much better off with gold bullion or the gold ETF.

Specifically, the Index underlying the GLDI ETN lost 34 percent of its value during this 4.5-year period (a $3,388 loss on a hypothetical $10,000 initial investment). This would have been offset by $7,500 in income payments, for a total pre-tax return of around $4,112 over the 4.5 years — vs. more than $8,000 had you held gold or the GLD ETF.

Why did the Index decline in value when gold rose?

• Remember that this Index’s upside is limited to 3 percent maximum each month, but the downside is unlimited.

During the 4.5-year period, there were five months with Index declines of 5 percent or more, three of these greater than 10 percent. Net results for the remaining 46 months were positive for the Index, but this was not sufficient to offset the five big losers, which together produced a loss of nearly 58 percent.

• Each month, the call options sold are bought back, in order to close out the position and roll the money into the next month’s call-option sales. The cost of covering is deducted from the index. This can offset some of the gain from the rise in gold prices.

Still, the $4,112 return on the GLDI ETN over this 4.5 year period equates to 9 percent annual return on the initial investment. This still seems like a very good return. But keep in mind your investment is not secured with any assets. If Credit Suisse runs into financial difficulties, you may well lose your entire stake.

Just as importantly, should gold prices drop dramatically over time, index losses could more than offset the income payout.

So while the income component of GLDI ETN can provide an attractive unsecured yield, returns on the underlying index can be a potential minefield.

GLDI: Unsecured, Variable-Rate Debt

Because of the catches mentioned above, GLDI is not a good way to invest in gold. Instead, it’s best thought of as variable-rate, unsecured debt. Under most scenarios, GLDI will make periodic, uneven payments, except for when:

• The Index value goes to zero;
• The 20-year termination date is reached;
• The ETN is extended to 25 or 30 years (a Credit Suisse option); or
• Credit Suisse opts to terminate the ETN before the 20-year termination date.

In all but the first situation, there would be a partial return of principal at termination based on the value of the Index at that time.

Bottom Line

No investment vehicle I know of lets you invest in gold and collect income from that investment. The new GLDI ETN is a way to have an indirect (and lopsided) exposure to gold prices and receive monthly payments.

However, under many market scenarios, GLDI will be losing principal over time, even if the price of gold goes up. GLDI is therefore best thought of variable-rate, unsecured debt for gold bulls.

Those of us seeking a dividend with fixed bullion backing will have to keep looking.

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John Lounsbury is managing editor and co-founder of Econintersect LLC, publisher of Global Economic Intersection.