Over the last 5 years the use of structured notes as an investment vehicle has exploded in the offshore investment market.  Institutions such as Nomura, Morgan Stanley and most recently a small Swiss investment bank EFG have provided notes of all shapes and sizes to financial advisors to offer their clients.

What is a structured note?

In general, a structured note is an IOU from an investment bank using derivatives to create the desired exposure to one or more investments.  For example, you can have a structured note deriving its performance from the S&P 500 Index (SPY), the Emerging Markets Index (EEM), or both or even individual shares.  The combinations are almost limitless.  If the investment banks can sell it, they can mix up just about any cocktail you can dream up and some you haven’t even thought of.

The most popular structured note in the offshore market is an auto-callable note with a snowballing coupon.   Typically a note will be based on 3-5 underlying indexes or stocks.   Let’s say it is a banking note that is based on the shares prices of JP Morgan, Citibank and Bank of American, it’s a 5 year note with a 3% quarterly snowballing coupon and has 40% downside protection.   The share prices of the note will be observed once a quarter and if the prices of all of the companies are above their initial (strike) price then your capital will be returned and the dividend will be paid depending on how many quarters it took for the note to be called.  So if it took two years your group of shares or indicies to beat the opening price, you will have a 24% return on your money.

The potential immediate downside to the investor is:

1. The note does not get called and your money is locked up for 5 years and achieves no return over that time period.
2. Even worse, the share prices of one of the entities falls more than 40% and you take a significant haircut on your capital. From memory, I remember a note that included Nokia and investors lost 80% of their capital.  I’m glad that wasn’t my client and it just goes to show how quickly a company’s fortunes can change.  Nokia was a star before Apple arrived.

Advantages of Notes

1. Diversification – structured notes may allow you to diversify your investment products and security types in addition to asset diversification.
2. Access – structured notes may give you to access to asset classes that were previously institutional only or hard-to-access.
3. Customized payouts, structured notes can have customized payouts andSome notes advertise an investment return with little or no principal risk. Other notes offer a high return in range-bound markets with or without principal protections.  And other notes tout alternatives for generating higher yields in a low-return environment.

Whatever your fancy, derivates allow structured notes to align with any particular market or economic forecast.  Additionally, the inherent leverage allows for returns being higher or lower than the underlying asset, which it derives from.  Of course there must be trade-offs since adding a benefit one place must decrease the benefit somewhere else.  As the saying goes, there is no such thing as a free lunch.  Moreover if there WAS such a thing, the investment banks certainly wouldn’t be sharing it with you.

Disadvantages

1. You have credit risk of the issuing investment bank.

Since structured notes are an IOU from the issuer, you bear the risk that investment bank forfeits on the debt.   Therefore it is possible for the stock market to be up 50% but the note to be worthless.  As a matter of fact, the underlying derivates could have a positive return but the notes could still be worthless, which is exactly what happened to investors in Lehman Brother’s notes sold by prior to its collapse.   Google “Hong Kong Minibond Lehman” to see what I’m saying – failure can and does happen.  A structured note adds a layer of credit risk on top of market risk.

2. Liquidity?  There isn’t any

Since structured notes rarely trade after issuance, it should be pretty clear that they are punishingly, excruciatingly illiquid. Everyone expects to hold structured notes to maturity but personal emergencies do happen.  Additionally, what if the market is crashing and another Bear Stearns or Lehman bankruptcy is looking like a real possibility?   Often your only option for an early exit is the original issuer and taking whatever price they offer, assuming they are willing or interesting in making an offer at all.

3. Daily Pricing is extremely questionable

The pricing accuracy is questionable since most structured notes never trade after issuance.  Prices are usually calculated by a matrix which is very different than net asset value. Matrix pricing is essentially a best-guess approach.  Who do you suppose does the guessing?

4. Advisor Conflict of Interest

From my experience, notes that have the greatest risk and the highest potential return to you as an investor, pays the highest commission to your advisor.   We would hope that all advisors are working in your best interests, but sadly when they are solely commission based, this is rarely the case.

Guidelines if you decided to invest in Notes:

1. Limit your portfolio exposure to structured notes, I’d recommend not more than 15% of your overall portfolio to be invested in this asset class.
2. Diversify by issuer, have notes that are offered by 2-3 different banks.
3. Request Full Disclosure, ask your advisor what he is making on the sale of the note, if their commission seems on the high side it may be a warning sign.
4. Beware if it looks too good, if the potential reward is very high there is also a high risk of failure.
5. Pay attention to the underlying assets, Notes that have decent potential payouts tend to have one outlier in its underlying assets, a company that has an ever-shrinking share price and may be under financial distress. The note then becomes a bet on the recovery of that one company.  This is a ticking time bomb.  A note based on market wide indexes is thus safer than a not based on 5 individual companies.

If you have an existing portfolio that has a large exposure to structured notes and you are concerned, we would be happy to consult with you and provide a course of action.   We can be reached atquery@caterergoodman.com or by phone at 021-33661337.

Bill Longstreet has been a financial advisor since 2003 and prior to this were a institutional business development director, specializing in fixed income and foreign exchange markets. Bill has a Master in Business Administration with a concentration in Finance (1999) from the Olin School of Business at Washington University in St. Louis and am a candidate for the CFP (Certificate Financial Planner) qualification. He also holds a Bachelor of Arts with a Major in Economics from Denison University. In his last position before joint Caterer Goodman oversaw $350 million in client funds across a range of currencies and risks profiles.