Structured-note returns too good to be true?

Jan 27, 2013 @ 12:01 am

By Bloomberg News

Here is an investment that sounds just too good: Investors get 150% of the upside of the stock market but just 90% of the downside.

That is the promise of structured notes issued by companies such as Bank of America Corp., The Goldman Sachs Group Inc. and JPMorgan Chase & Co.

Such hybrid securities, which have maturities like bonds but are linked to asset classes such as stocks, currencies and commodities, are increasingly popular. That is especially true for notes linked to the stock market, which has risen 16.5% in the past year and 116% since the March 2009 bottom.

Some $10.1 billion of structured notes tied to the S&P 500 were issued last year, the highest amount in three years, according to data compiled by Bloomberg.

DOWNSIDE BUFFER

Consider one of JPMorgan's 18-month buffered return-enhanced note, which are linked to the S&P 500. Issued Oct. 26, they mature April 30, 2014.

For that time period, the notes promise to deliver 1.5 times the S&P 500's gain when they mature. So if the S&P 500 is up 6% as of April 30, an investor in the notes gets a 9% return.

The notes also provide a downside buffer of 10% so that if the index falls less than 10% below its initial price Oct. 26 — 1,411.94 — shareholders lose nothing. Any loss greater than 10% is on the note holder.

So if the index is down 20%, you are down only 10%.

That doesn't sound so bad until you read the fine print in the note's prospectus: “The notes are designed for investors who seek a return of 1.5 times the appreciation of the S&P 500 index up to a maximum return of 14% at maturity. Investors should be willing to forgo interest and dividend payments, and, if the ending index level is less than the initial index level by more than 10%, be willing to lose up to 90% of their principal.”

A few things in those sentences should give investors pause.

First, there is that 14% cap.

Because market returns tend to be lumpy, there are often years where the market is up 26.5%, like 2009, and other years where it does next to nothing, like 2011, when it returned 2.11%. Capping the upside at 14% could mean giving up a lot of return in a strong year.

And if the market returned just 2.11% over the life of the notes? That would translate into a 3.16% return.

Alternatively, if the market were down 20% when the notes matured, they would absorb the first 10% of the loss, and the rest would come out of the investor's principal. The reward doesn't seem quite worth the risk.

What's more, forgoing dividends is a big deal. Although just 2.2% in the average stock, dividend yields have accounted for 40% of investors' returns historically.

CREDIT RISK

It gets worse. Unlike traditional index funds, which hold a diversified basket of stocks, structured notes are exposed primarily to the credit risk of issuers.

In 2009, securities lawyer Jacob Zamansky won the first of several arbitration cases against UBS Financial Services Inc. for selling structured notes issued by Lehman Brothers Holdings Inc. The notes, which were designed to be 100% “principal protected” — meaning that holders shouldn't have been able to lose money — lost most of their value when Lehman went bankrupt.

MISCOMMUNICATION

“Investors were led to believe there was no way they could lose money — that the only downside is that they'd get the return of their principal,” Mr. Zamansky said.

“UBS never explained to them in writing or in conversations that these principal-protected notes were subject to the creditworthiness of the issuer,” he said. “There are hundreds of cases like this because of this miscommunication.”

“UBS maintains that the Lehman Brothers structured-product-offering materials adequately disclosed credit risk and that the vast majority of its Lehman structured-product sales were conducted properly,” UBS spokeswoman Megan Stinson said in a statement.

Unfortunately, there is an incentive for brokers to be less than forthcoming about the risks of structured notes. They get commissions anywhere between 1.5% for a standard S&P 500 note to 10% for more exotic notes tracking custom benchmarks.

These commissions aren't so easily detectable to investors, because the issuer of the note pays the commission to brokers, rather than the investor's paying, for example, a mutual fund's front-end loads. Unless investors read a note's prospectus, they won't necessarily know that the broker has an incentive to sell it to them.

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