The rise of financial engineering in recent years has resulted in the creation of a new class of investment vehicles called structured products. Issued by investment banks, structured products have a fixed maturity and two major elements: a note and a derivative.
Structured notes are similar to bonds but do not pay a fixed interest rate. Rather, they pay based on the fluctuation of an underlying index or security such as the S&P 500 or the Russell 2000. Most notes also offer a combination of principal protection and/or leverage combined with the underlying investment's return.
Structured products are not an asset class in and of themselves any more than mutual funds or exchange-traded funds are. They are typically distributed like bonds and have a CUSIP. And, as with bonds, their ultimate payment is an obligation of the issuing bank, so the credit rating is very important, as investors in structured notes that relied on Lehman Brothers as a counterparty sadly discovered.
Structured products offer a way to diversify clients' portfolios by exposing them to investment strategies they otherwise would have difficulty accessing. The derivatives involved often feature the characteristics of option pricing, swaps, forwards or futures, all of which have become more popular with the rise of hedging and other sophisticated risk strategies.
There are many different structures that track a plethora of underlying investments, including broad-based indices such as the S&P 500, the spread between 10-year and 2-year Treasury notes, and long/short hedge fund strategies, to name a few. Structured notes can be linked to equity, fixed income and commodities as well as alternative investment strategies. Some can be very "plain vanilla" while others can become quite complex. The performance of the note depends on the underlying investment's performance during the term of the note. For example, during the current bear market, certain notes created to profit from an increase in the S&P 500 have lost value, while one that was designed to profit from a decline in financial stocks would be doing well.
Two of the most basic strategies are the "100% principal protected note" and the "enhanced return note." With the first, the client's principal is guaranteed, and with the second, the client receives upside leverage and some downside protection.
100% Principal Protected Note ith this basic form of structured product, the issuer guarantees the higher of:
Your initial investment
100% of the underlying index's appreciation (not including dividends)
This is done with a combination of a zero coupon bond and a call option. As an example, assume a $1,000 initial client investment. The issuer will invest as follows:
5-year zero coupon bond at 4.56% $800
5-year call option on underlying index $150
Issuer's fee $50
Total cost $1,000
At the end of five years, the zero coupon bond will mature and be worth $1,000. So, the final payout at the end of five years will be the bond's value of $1,000 plus the value of the call.
Scenario 1: Underlying Index
Appreciates 20% In Five Years
Bond proceeds $1,000
Option value $200
Note payout $1,200
ROI 20%
If the index appreciates 20% over that period, the value of the call option is $200 and the investor will receive that plus the $1,000 from the bond for a total payment of $1,200, which is a 20% return on the initial investment.
If the underlying index either declined in value or stayed the same, this is what the investor will get:
Scenario 2: Underlying Index
Declines Or Stays The Same
Bond proceeds $1,000
Option value $0
Note payout $1,000
ROI 0%
Note that the call option represents only the price appreciation, not dividends. In other words, an investor will forgo any dividend income received during the term of the note.
Enhanced Return Note
This is another popular and useful structure. There is generally a cap on upside return, leverage up to the cap and occasionally some downside protection. For example:
18-Month Enhanced Return
Note Linked to the S&P 500
Max upside 20%
Participation rate 2x
Buffer 90%
In this example, the investor has agreed to invest for 18 months, limit their return to 20% over that time, receive double their return up to the 20% limit, and risk only 90% of their money (in the event the underlying investment, the S&P 500, goes to zero). (See Figure 1 for hypothetical payoffs.)
As you can see, if the market makes an upward move greater than 20%, this underperforms an S&P 500 Index Fund. However, in all other scenarios, it outperforms. As with the principal protected structure, this deals with the appreciation only and does not include dividends.
Factors To Consider
When should you place a structured note in a client's portfolio? You must consider where to position such an investment within the portfolio, how the fees will be set up, the tax implications, and how the structured note fits in with the client's risk tolerance profile.
Portfolio Positioning
To determine where to place these securities in an account, it is important to note the underlying index or strategy. For example, a note tied to the S&P 500 could be considered as part of a client's U.S. large-cap stock allocation. Alternatively, a portfolio manager may prefer to keep these separate from the client's more traditional allocation in a category called "hedging strategies" or "alternatives."
Either way, do not break the note apart into its individual components and treat them separately. For example, in the principal protected note above, you would not want to consider it 80% fixed income and 20% large-cap stock, because it would be difficult to accurately account for the balance between these two pieces as the note approached maturity.
Fee Structure
As with any investment, fees matter. The principal protected note example assumed a fee of 1% per year for five years, or $50. If the fee were not there, the $50 could have been used to make the investment more attractive. For example, it could have offered the appreciation of the underlying index plus 5% return instead of simply your money back.
Alternatively, the $50 could have been used to purchase more call options that would have offered leverage. For example, if $150 could buy 100% exposure of the underlying index, the extra $50 could have bought 33% more exposure for a total of 133% of upside performance.
The fee is not taken up front; rather, it is taken over time. In other words, when the note shows up on the client's statement, it will be listed at its full value, $1,000 using the example above, and not $950. One method is to take 1 basis point per day until the expenses are paid. In the above example, the issuer would take 1 basis point each day for 500 days to receive the total fee of $50.
The terms of the note are net of expenses. For example, if an 18-month note on the S&P 500 pays up to 20% and the index actually appreciates 7%, you will get the full 7%-the expenses are not subtracted.
Some issuers of these notes create two "classes," one for advisors and one for brokers. The latter class factors in a commission to the broker, so the terms of those notes are less favorable to the client.
Tax Implications
The tax treatment of a structured note depends on how much is at risk. In the case of 100% principal protected notes, all of the gain is taxed at ordinary rates. In the case of the enhanced return notes, it is usually taxed at long-term capital gain rates. You must check the offering sheet of the issue to determine the expected tax ramifications.
Risk Considerations
There are various risks associated with structured notes, starting with credit risk. The note is an obligation of the issuer, similar to a corporate bond. If the issuer goes bankrupt prior to the note's maturity, you can lose your entire investment. To put this in perspective, Lehman Brothers was an issuer of these notes. At the time of this writing, investors in Lehman structured products are waiting in line with the bank's other creditors to see what, if anything, they will get back. Also, Bear Stearns was an underwriter of structured products, and had the bank not been purchased, the holders of its notes would have been in a similar situation to Lehman's investors.
The second risk is more of a disadvantage: Many notes do not factor dividend income in their return. For example, assuming the S&P 500 dividend yield is 2% per year and you hold a one-year note, and the value of the index is unchanged at the end of the term, your rate of return is 0%, compared with the 2% return had you invested in an S&P 500 mutual fund or exchange-traded fund.
Another risk is that the notes are relatively illiquid; the secondary market is limited. To mitigate this risk, only funds that will not be needed during the term of the note should be used for investment.
Other risks are specific to certain types of issues only. For example, consider a common structure called a reverse convertible in which the investor is paid a coupon as long as the underlying stock does not decline in value by a predetermined "buffer" amount. If the stock does decline, the investor will be "put" stock. In other words, he will receive the depreciated shares in lieu of any interest payment. During the current bear market, this risk has become apparent:
Six-Month Reverse
Convertible Tied To Arch Coal Inc.
Coupon Payment 19%
Downside Buffer 30%
Initial Investment $1,000
Scenario 1
Closing Price
4/25/2007 $37.40
10/29/2007 $41.15
Percentage change 10%
Investor receives:
Initial investment $1,000
10% coupon $190
Total payment $1,190
Scenario 2
Closing Price
4/25/2008 $57.90
10/29/2008 $20.27
Percentage change -65%
Investor receives:
Shares worth $350
Total payment $350
The way a structured note is set up can affect risk on both sides of the ledger. For instance, some notes are "point-to-point," meaning that to determine their final value, only the starting and ending values are considered. What happens in the interim is irrelevant, and this is usually an attractive feature. Other structures have "knockout" features if certain levels are breached. For example, a note may promise to pay the return of the S&P 500 up to 25% as long as 25% is never breached during the term of the note. Very often, if the barrier of 25% is hit, the note will simply return the initial investment at maturity, in which case the investor's rate of return is 0%.
Another structure uses an averaging strategy. This is not necessarily a disadvantage, but it does alter the return, sometimes substantially. Assume a one-year note that "averages" the monthly values of the S&P 500. The final return compares this average value to the initial value to determine the percentage return. See the table for examples of this. For the period ended December 1, 2006, a point-to-point investment (such as an S&P 500 mutual fund or exchange-traded fund) would have returned 10.8%, but an "averaging" investment would have returned 3%. On the other hand, in a declining market such as that of 2001, the point-to-point investment returned a negative 16% while the averaging investment returned a negative 13.2%. (See Figure 2.)
Doing It Yourself
You may be wondering why you should pay a bank to do this when you can buy zero coupon bonds and call options on your own. There are a few reasons: First, it is not always possible to get a call and a zero coupon bond that have the same expiration date. Second, you may not be able to find a call that has a strike price that is the exact price at which the underlying index is currently trading. Third, you would have to buy an individual bond and option in every account separately. Fourth, and most importantly, options may not even exist for the term you need. For example, five-year call options on the S&P 500 are not readily available; they need to be customized by an investment bank. Lastly, some structures combine different underlying securities, for example a 50% weighting between the S&P 500 and Russell 2000, and options on the combined investment do not trade on exchanges.
How the Banks Do It
Every month, the banks put together structures that will close a few weeks later. In addition, many banks can customize a note to an advisor's view on a particular market. In order to come up with the terms of the notes, the underwriters use option and bond pricing models that factor in the current interest rate and volatility environments.
However, after the pricing is determined, the underwriters usually do not go out and buy the bonds and options. Rather, they manage their entire book of business as the underlying indices change in value and hedge accordingly. This may make certain investors uncomfortable, but when buying structured products, the investor needs to trust the underwriter's risk management protocol.
A New Opportunity
In conclusion, structured notes represent a new investment opportunity in that they quantify a risk/reward trade-off. It is very important to read the offering documentation to fully understand the payment terms and expected tax ramifications of a particular issue. If considered in this way, they can be a useful tool in better managing clients' portfolios.
