Low risk high yielding? Or high risk moderate yielding?
Structured Notes were banned for sale to retail clients in the UAE by the Central Bank in 2009
Structured notes are not regulated and are meant for institutions and professional investors.
If you are going to invest or have invested, then please read this.
What is a structured note?
A structured note is nothing more than a promise from a financial institution to pay you in the event of certain market movements.
They use derivatives to simulate an investment structure. The combinations are limitless and as such they can create anything you want, but this may not necessarily something you need.
- The stated advantages of Structured Notes used by sales people debunkedDiversification of portfolio
This makes no sense if the portfolio already consists of equity investments. There is such a thing called over diversification and pointless diversification. This one goes under the category as pointless. All it does is create a concentration of risk (too many eggs in one basket). Due to the risk it would only make sense if it was a small portion of your diversified portfolio.
2. An income with an element of capital protection or is it possible to produce a low risk note?
It is but you will not get the level of income and you still need to understand that you have now added credit risk (the ability of the issuing institution being able to honour the note.
When the note comes to maturity this provides an opportunity for the adviser to sell another note generating a similar amount of commission. These high commissions come from the return you should be making. These structured notes are very illiquid and will not help if you suddenly need liquidity.
3. Participation in the upside of stocks or a collection of equity markets with an element of capital protection
As the saying goes “There is no such thing as a free lunch on Wall Street.”
There has to be a trade-off, if you add a benefit then you have to decrease the benefit somewhere else, you may be getting paid dividends or coupons but you are limited to the profit you can make. It may belong as a small portion of a portfolio, however due to the credit risk it should never be a large part of your portfolio. If the risk was really so low, we would have seen financial institutions putting lots of money into those notes instead of issuing notes.
Most of the notes have worked well in the last few years due to the side ways market movement, however history paints a different picture.
- No entry costs or exit costs upon maturity (basically the charges are built into the lower returns)
Unfortunately, the answer in many cases comes back to how the adviser is paid. A lot of the structured notes that are available in the market pay commissions to the advisers of 3, 6 or 7 per cent when they are purchased.
Tip: If you were needing to buy a note it might be a better option to buy the product on the secondary market after the note has listed. You will almost certainly buy the note at a large discount to its original price and the cost to buy will be the trading fees. However, you would still have to accept that the underlying price of the note will fluctuate in value and not necessarily in a positive manner.
- The ability to receive an element of protection in the form of a limited capital guarantee from a highly rated bank
Sometimes the word guaranteed is accidently used. The term is capital protection. What must be understood is who is providing the protection. This is in the small print. Who is providing the protection and where is this institution based? It is often the subsidiary of a major bank, not the major bank itself. Ratings normally start at AAA and once you get to BBB- then you are at junk status. Ask your advisor what the risk rating is as he “should” know. If he does not know then you should avoid investing in any product where the risk is not clearly defined. Lehman defaulted on USD 76 billion in Structured Notes despite the guarantee.
- Our notes have never lost money!
This may be true, but this does not reflect the entire structured note market, or the history of structured notes.
In the aftermath of the 2008 crisis, many financial institutions defaulted on the structured notes. Lehman alone defaulted on usd76 Billion.
- You get access to a particular asset class normally onlz available to institutions.
This may have been a fact many years ago, however there are so many investment structures you can access via ETF’s (Exchange Traded Funds) and Mutual Funds with lower costs and lower risks.
The only benefit that makes sense is that structured notes can have customised pay-outs and exposures. Some notes advertise an investment return with little or no principal risk, some quote higher returns in range bound markets with or without this protection and yet other notes often sold as generating high yields in a currently low yield environment. Sounds complicated but it is not.
Whatever you choose, derivatives allow the structured note to replicate a particular market or forecast. It is synthetic (does not use the actual shares) and often uses leverage (borrows money) to generate returns higher or lower than the asset it is supposed to replicate.
7. If a client asks about liquidity
The advisor may tell you there is a secondary market.
Liquidity, what liquidity? –. Structured Notes do not tend to trade after being issued
In fact, the term is “Illiquid” You are expected to hold the note till maturity.
However, in life, changes happen, what happens if you require money due to losing a job, another investment opportunity that you should take, what happens if we have another financial crisis similar to 2008. The only possibility is to go for an early exit and take any price the issuer offers you, that is assuming they are willing to make an offer.
Daily Pricing is extremely questionable. – As most of those notes do not trade after being issued, then it is logical that the prices being quoted on your statement are not actual prices you can sell at.
They are instead calculated using algorithms which is completely different than a net asset value.
As such the valuation is merely a guess at the best. If it is not the market that gives the price, who do you think it is?
So what are the disadvantages of Structured Notes?
Credit Risk – I mentioned that they are an IOU (promise) from the issuer, as such you bear the risk that the financial intuition can make good of the guarantee. ARC Capital, Keydata, Bear Stearns and Lehman are just a few that defaulted on the guarantee, Lehman alone defaulted on USD 76 Billion of structured notes. As such it is possible that the market is down 50% but the note is still worthless. It could even have a positive return and also be worthless. You are basically adding credit risk on top of market risk. Notes mostly do not have a risk rating, unlike bonds. If the financial institution goes into insolvency, then these notes are worthless.
In fact, the UK financial watch dog Martin Wheatley referred to them as “spread betting on steroids”
Mutual funds, stocks, ETF’s etc. will be segregated assets in your account. They may be down, but they still belong to you and have a chance of recovery. If the financial institution holding your account goes into bankruptcy, your assets will be transferred to another institution. Structured notes will remain as a promise by the institution to pay you after all other creditors have been paid.
Fees – fees and commission can be very high. This is what makes them attractive for the issuer and the advisor selling them “The higher the fees the lower the returns”. It is however possible to create your own structured notes with higher returns.
Who cares about credit risk, liquidity or pricing? – Let me give you an actual recent case study:
- RBC Phoenix A/Call Note Linked to 5 stocks
Cusip XS1978174411 issued July 18 2014 mature July 18 2019
Potential to return 12% p.a. with a defined level of risk and potential quarterly redemption.
Regular income and considered defensive.
What the client was not informed was that it was only meant “for professional investors only and not for Retail distribution”
The client was a low risk investor with issues about job security.
The position was valued on Jan 14 2016 with a loss of 59.28%
To know more or if you have questions please contact the author