Structured notes have emerged in recent years as a new, exciting investment opportunity quickly being absorbed into the mainstream financial services industry. $64 billion in structured products were issued in the U.S. in 2006, a 33 percent increase from 2005, according to the Structured Products Association. It is speculated that the structured products market will break $100 billion in 2007.
Structured notes should not be confused with other investments that have been hit hard by the credit crunch and subprime mess, including collateralized debt obligations and structured investment vehicles. Structured notes are financial instruments that combine derivatives with equity or fixed income, resulting in customized risk and return profiles.
Because profiles can be structured to match any investor’s comfort zone, the notes offer a way of investing in an asset class that would otherwise seem too risky, Bob Gordon, president of Twenty-first Securities, said. Some types of structured notes, such as exchange-traded notes (ETNs), are favorable from a tax standpoint as well. ETNs—which are distinct from exchange-traded funds (ETFs)—may be tax-deferred until they are traded or reach maturity. Additionally, ETNs that are held for longer than a year receive long-term gain treatment.
“I think there are tax advantages to the capital gains treatment in the structured notes which can’t be matched by other investments that are out there,” Gordon said.
Some consumers have bought structured notes without necessarily knowing it in the form of a certificate of deposit (CD), Gordon said. A CD that yields returns based on a specific market, such as Everbank’s Gold Bullion CD (see our article on Investing in Gold and Silver CDs for more information), is a form of principal-protected structured note, where the principal is guaranteed at the time of maturity, regardless of market performance. In exchange for the reduced risk inherent in principal protection, an investor may also face lower potential for return, depending on the note structure; in some cases, he or she will not be able to acquire dividends and interest or keep a full percentage of capital gains.
Structured products are a diverse type of investment; while principal-protected notes are perhaps the simplest form of structured investments, structured notes that do not guarantee principal are far more common and complex, Gordon said.
JPMorgan, for instance, sells buffer zone investments and return-enhanced investments in addition to principal-protected notes. Buffer-zone investments protect a percentage the principal; there is potential for higher returns, usually with a limit on maximum gains. Lastly, return-enhanced investments do not guarantee any principal, but offer the potential to double or triple market returns within a limit on maximum gain.
The types of structured notes that are available vary according to an individual investor’s qualifications.
“I think that some of them are only offered in the high net-worth space because of certain investor qualifications [that] relate to income or sophistication,” Gordon said.
However, base-level structured notes, such as structured CDs and ETNs, are available to almost everyone. Investors who are interested in ETNs may want to act soon, however, as tax advantages are likely to be taken away.
“I believe that the government is going to change that law sooner rather than later,” Gordon said. “This might be a good time [for interested consumers] to buy them, before the law is changed.”
When it comes to the potential downside of investing in structured notes, “the devil’s in the details,” Gordon said. Especially with non-principal protected notes, investors may not realize the extent of risk exposure. A reverse convertible, for instance, is a structured note that has a lot of downside risk, similar to a naked put; in some cases, this type of risk/return profile is not immediately apparent.
While structured notes do not have direct ties to the subprime market, it is important for investors to carefully discern an issuer’s ability to honor the note during this time of turbulence in the financial services industry, Gordon said.
Many large banks, such as JPMorgan and Merrill Lynch, offer a range of structured investments; interested investors can use web resources such as structuredinvestments.com to view listings of institutions that issue structured notes.