September 2007
Unstructured Debate
By CAREN CHESLER
Structured notes are either the greatest thing since sliced bread, or the worst thing since typhus. It depends on whom you ask.
A creation of the large investment banks, structured notes offer a way for individual investors to diversify their portfolios away from traditional stocks and bonds and invest in more novel asset classes, like commodities, international equities and real estate. Their structures vary widely, but most mature in three to five years, contain principal protection and offer investors a leveraged bet on markets to which they would not easily have access.
Indeed, interest in the product has grown significantly over the last several years. Nearly $64 billion in structured products were issued in 2006, up 33% from the $48 billion notional amount issued in 2005, according to the Structured Products Association. Part of the reason is that, like many products originally geared toward the ultrawealthy, they are now marketed to the wealthy masses.
“When these things first came out, only the very wealthy could afford the million-dollar minimums. But now they’ve become so commonplace you see deals with $10,000 or $15,000 minimums, so even smaller players can take advantage,” says Leroy Tanker, president of Atlanta-based Freedom Financial Services and a financial advisor with Raymond James Financial Services.
Structured notes have three main components: some type of underlying bond, such as a zero-coupon bond, to provide principal protection; a customized option, which is structured to carry upside with limited downside; and the fees that go to the investment bank that structured it. The notes often have 100% principal protection and offer investors some participation in the upside of the underlying security.
Tanker says he recently put some clients in three-and-a-half-year notes that were based on a basket of commodities, and investors not only had all of their principal protected but were able to participate in 140% of the upside. So if the basket of commodities was up 10% over the three-and-a-half-year period, investors received 14%, thanks to options that leveraged the investment, Tanker explains.
But he says the tax consequences of the structure can be tricky. The notes are billed as having returns that are taxed as long-term capital gains at a rate of 15%, rather than ordinary income. But the zero-coupon bond component can accrue interest along the way, and that is taxed as ordinary income. The result is that investors could wind up paying a tax rate of 35% on income they have not even received.
For that reason, some advisors will not buy them for clients with taxable accounts. They reserve them for those investing in IRAs or other retirement accounts, Tanker says. “You have to be very watchful of the tax consequences,” he warns.
Structured notes are for people who don’t mind risk and volatility, and yet the product doesn’t really have either, says Matthew Chope, financial advisor with the Center for Financial Planning Inc. in Southfield, Mich. “You can have 100% principal protection and invest in something that would otherwise be very risky. That’s the big benefit,” Chope says. “It’s a way for people to invest in risky investments without the downside.”
Chope explains the product this way: An investment bank might sell a $100 structured note in which $95 was used to buy a zero-coupon bond for principal protection and the remaining $5 would be used to purchase an option. Some products also contain buffers against losses; a note with a 20% buffer means the underlying asset could fall 20% before the investor takes a hit.
Chope says the product is structured so that it mitigates the roller coaster ride some investors experience as their investments are whipsawed by the vagaries of the markets. “People will knee-jerk pull themselves out of an investment because they’re scared out of their wits,” Chope says. “But studies have shown that people who can manage their emotions are the ones who are most successful and the most well-off. This kind of product takes some of the emotion out of the equation.”
The downside is that with maturities of three to five years, the product ties up an investor’s money for some time. Those wanting out are subject to the whims of a secondary market that lacks liquidity. For that reason, even advisors who like the product say investors should not allocate more than 25% of their portfolio to structured notes, and that allocation should be spread among several deals.
“Done in the right proportion, and filling the right need, they make sense,” says Louis Stanasolovich, president and chief executive officer of Legend Financial Advisors in Pittsburgh.
But the fees can be high, he says. Some carry hefty structuring fees of 2% to 3% as well as sales fees ranging from 1.5% to 3%, depending on the product’s term. While larger firms like his can reduce the fee by taking down a larger portion of the deal, the cost is still high relative to other investments. The structures are also somewhat complicated to understand, he says. “It took us six phone calls with these investment bankers to understand these, and I don’t think we’re stupid,” he says.
The more skeptical advisors wonder whether anyone really understands the product—outside of the investment banks structuring them. If they did, they wouldn’t be buying them, says Stephen Barnes, a portfolio manager at Phoenix-based Barnes Investment Advisory. “I hate these things,” Barnes says. “I think they’re just moneymakers for the bankers, and they’re oversold.”
All the reward without the risk? Right, Barnes says. “That doesn’t happen. These are not products for sophisticated investors, because frankly, I don’t think sophisticated investors would buy products like this.”
The notes can be based on anything, and usually involve sectors that are hot. About a year ago, it was notes based on gold. Six to eight months ago, it was deals tied to European equities. Commodity-related products, which give investors exposure to the infrastructure buildup in China, India and Brazil, also have been hot for the last year.
Barnes says the machinery at the brokerage firms goes into high gear and produces structured notes tied to whichever sectors are hot. “It’s very much flavor of the month. Whatever stocks are moving, that’s what you get calls on,” he says. “If they can promise you a 9% or a 12% coupon, and if you don’t read the material, that sounds almost too good to be true, which of course it is.”
Barnes says not only wouldn’t he dream of putting his clients into the product, but he’s had to spend a fair amount of time getting new clients out of them. That’s because the structure is inherently problematic, he says. It shifts the risk/return profile of the underlying security negatively to the investor. That is, investors receive less upside from the underlying security than they would ordinarily receive had they bought the security outright, and yet the downside exposure remains the same.
Likening it to a covered call, he explains it this way: Say investors want to buy shares of Newmont Mining Corp. A structured note deal would give them that exposure, but instead of their having to wait for the stock to go up, the deal would pay them some of that upside income up front. But it comes at a cost: The deal is structured so that they give up some of the upside if the stock shoots up in price later. And yet because the investor still owns the stock, he is exposed to all of its downside if the stock price falls. (See sidebar.)
“So you accept less upside in order to have an income stream, but you retain essentially all of the downside,” Barnes says. “Part of the reason you’ve given up some of the return is because the broker must take their cut.”
Not everyone realizes this because the fees on these deals are essentially hidden, Barnes says. And in fact, the only people who really know the size of the fees being generated are the investment banks structuring these deals, he says.
“I’ve been around. This ain’t my first rodeo. I know how these things work,” he says. “They’re doing this to make money, and it’s much easier to make money when they’re not telling you how much they’re making.”
Robert Gordon, president of New York-based Twenty-First Securities Corp., gives the product a more mixed reception. He says some deals add value, while with others, investors would have been better off creating the commodities or real estate play themselves. “I don’t think you should paint them all with one brush,” Gordon says.
A $100,000 structured note that offers principal protection based on the upside of American stocks is not particularly novel, Gordon says. Investors would be better served taking $80,000 and buying, say, a five-year U.S. Treasury zero-coupon bond, which would guarantee to give them $100,000 at maturity. Investors could then spend the remaining $20,000 on call options on the S&P 500. That way, they save 200 to 300 basis points in fees and are not subject to the credit risk of the investment bank that structured the deal, he says.
“If someone thinks they’re buying a note that guarantees them their principal and pays 12%, they’re wrong, and they’re being sold a bill of goods,” Gordon says. “Those products are nothing more than naked put selling—which most clients wouldn’t do—wrapped in the flag of a 12% note. The problem is, most people don’t know what they’re buying.”
Barclays’ exchange-traded notes, on the other hand, are a different story. Gordon believes they are a very good product because the exchange provides much-needed liquidity, the fees are low and there is less counterparty credit risk.