Investment Insights

Jeff Benjamin

The latest wrinkle in cash alternatives

These offerings can deliver higher returns, but look under the hood before buying them

May 29, 2011 @ 12:01 am

With interest rates hovering near zero, it shouldn't surprise financial advisers that the structured-products industry has been promoting its cash management alternatives.

In these products, annual yields can top 10%, and principal is guaranteed if the investment is held to the six-year maturity. But as with most structured products, there is a lot going on under the hood, so it is wise to study the mechanics before taking ownership.

Still, as long as advisers and investors proceed with their eyes wide open, these particular coupon-generating products could be the right thing at the right time.

Marketed as annual-income products, income generators and yield generators, these investments are designed and promoted as an alternative to low-yielding certificates of deposit.

“Right now, everyone is focused on risk mitigation, but they still have to grow principal,” said Randy Pegg, executive vice president at Advisors Asset Management. “The annual-income product has become one of the most popular products over the past 18 months.”

Although the structure of each product will vary based on the issuing firm, the annual yield typically is pegged to the performance of a basket of 10 to 20 stocks.

If, after a year, for example, the average return of the underlying portfolio is up 6%, the investor receives a coupon payment equal to that amount.

When compared with CD rates that aren't even keeping pace with inflation, the opportunity cost is minimal. If, after six years, the underlying basket is flat or below water, the investor is out only the 3% commission or comparable fee for a fee-based version of the product.

But here is where looking under the hood pays off: Calculations involving the performance of the underlying basket of securities differ among the products.

Although the annual coupon is based on the performance of the underlying securities, the products often cap the performance of each security to match the cap of the overall product.

For example, if one of the 10 underlying stocks gains 20% in a given year, that performance could be capped at 10% when calculating the performance of the total stock basket. In essence, in order to earn the 10% annual maximum coupon, each underlying stock might need to gain at least 10% in a given year.

Then there is the downside protection twist.

If held to maturity, the principal is guaranteed, but the annual coupons are based each year on where the underlying portfolio was at the start of the six-year term. This can be a good thing if stocks are rising, but it also means that investors must recover from a down year before any coupons are paid.

Most of these products will place limits on the downside, but those will be about three times the limits on the upside. For example, a product might limit losses to 30%, but if a portfolio falls that much, it could take a 60% return to break even.

Responsible advisers will let their clients know that performance of the underlying basket should be considered a driver of performance but not an official measure of performance.

Remember, these particular structured products are designed to turn equity into a coupon-bearing instrument as a way to compete with CDs. They aren't designed to, nor will they ever, keep pace with the stock market.

“We find that sometimes the expectations of investors will get reset, based on what the stock market is doing,” said Scott Miller Jr., managing partner at Blue Bell Private Wealth Management LLC.

With that in mind, Mr. Miller, whose firm manages $280 million in assets, has been buying some of these products on the secondary market, which sometimes involves paying a $25 prime brokerage fee but avoids the commission.

Ultimately, choosing these products boils down to education and managing client expectations, because when compared with CDs in this environment, they can be viewed as a low-risk source of yield. But if advisers are looking for an alternative to equities, this isn't it.

Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.

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