Posted by on Oct 20, 2014 in Blog, Columns |

By Jason Zweig | 1:37 pm ET  Oct. 17, 2014
Image Credit: Christophe Vorlet

Whenever the stock market turns turbulent, brokers and financial advisers trot out structured notes as an alternative.

These short-term bonds are typically structured to limit or eliminate your exposure to losses while giving you a stake in potential gains, making them especially alluring in weeks like the one we just had, when stocks were glowing red. But whether you should buy them depends on the exact terms of each note—and on whether you can trust your adviser when he says he understands them.

Structured notes follow fear and volatility the way mushrooms sprout after a rain. Over the two weeks ended Oct. 10, 343 structured notes totaling $2.17 billion were issued, up from 144 deals worth $909 million in the same period last year, according to Joseph Halpern, chief executive of Exceed Investments, a New York-based firm specializing in structured products.

And no wonder. At its low point this past week, the S&P 500-stock index had fallen 9% in price from its peak in September—enough to spook many investors. Meanwhile, structured notes offer the hope of attractive income—often 3% or more annually—along with at least some protection against losses in stocks.

What is a structured note? It is unsecured debt issued by a bank or brokerage firm. The amount of money you get back is pegged to the performance of other assets, usually stocks or broad market indexes. They are sometimes marketed by less-scrupulous financial advisers as a kind of high-yield, low-risk, backdoor way to own stocks, even though regulators have warned that investors can get burned.

These notes can be tied to stocks or other assets in countless ways—not all of which fully guard against loss. Consider some recent examples.

On Oct. 6, Goldman Sachs Group issued $1.5 million in structured notes linked to the Russell 2000 index of small stocks. If the return on that index (excluding dividends) is anywhere between a 15% loss and a 25% gain as of the maturity date of January 2017, you would earn 20.9%, or about a 9% average annual return, on this note.

So you are protected against moderate losses and participate almost fully in decent gains.

But if the Russell 2000 goes up more than 25%, the note will pay no income at all; you will merely get your principal back. And if the stock index goes down more than 15%, you will lose money, with the potential for your investment to go to zero, according to the offering document.

Notes priced by Credit Suisse on Sept. 30 have their own wrinkle. Here, says the prospectus, you would earn 16.5% if neither the S&P 500 nor the Russell 2000 loses more than 10% by the note’s maturity in October 2015. If either index loses between 10% and 20%, however, you will get only your original investment back, with no income. And if either index goes down more than 20%, you will lose twice as much.

In short, if the worst-returning index falls in price by 10%, you earn 16.5%. If it falls 20%, you break even. If it goes down 20.01%, you lose 40.02%. If it drops 50% or more, your investment goes to zero.

With notes like these, “you’re betting on a very specific, narrowly defined outcome,” says Mr. Halpern of Exceed Investments. “And you can really be punished if you end up with something outside that outcome.”

The Goldman and Credit Suisse notes were custom-designed to meet the specifications of particular clients, according to industry sources.

On the other hand, some structured products are quite simple. On Sept. 30, for instance, Goldman issued $1.7 million in seven-year notes linked to the Euro Stoxx 50 Index, a bundle of leading European equities. If the index is higher at the end of September 2021 than it was at the end of last month, you get 105% of the price gain; dividends don’t count.

What if the Euro Stoxx index goes down? Then the note will pay you back 100% of your investment at maturity. So if you are willing to lock up your money for seven years, incur a 4.4% commission and pay tax along the way on income you won’t receive until maturity, it isn’t a bad way to bet that depressed European stocks will recover in the long run.

Before you buy any structured note, make sure you—and your financial adviser—know what you are doing. Ask: What are the specific risks this note will protect me against? Is there a cheaper, simpler way of accomplishing the same objective? What is the most I can make? If the underlying assets go down 10%, exactly how much will I lose? What if they fall 20%, 30% and so on? What is the most I could lose? When will I receive the income, and how will it be taxed?

If your adviser can’t answer your questions about potential losses without hesitation, he probably doesn’t understand the note as well as you need him to. It is his recommendation, but it is your risk.


Source: The Wall Street Journal