Gil’s Musings

Structured Notes Deconstructed

structured notes

We occasionally see portfolios come in for review containing structured notes. There are a wide variety of them, so I will speak generally. Not everything I will say applies to all, but likely most.

A structured note is a bond from a brokerage firm or sponsor which represents an underlying derivative. Most often, this derivative is a set of option contracts. The underlying derivative is what sets the parameters of upside vs. downside and can make them seem like a viable proposition. An example would be a note issued by UBS that is pegged to the SP500. Purchasers can expect to have annual losses capped at -10%, while annual upside is capped at +15%. While this could appear an attractive risk/reward, the limitations can prove problematic. Imagine that the market returns -11% in years one and two and returns +35% in year three. Investors would have losses in the note, while market investors experienced +6.9% overall. 

Structured notes typically suffer from a host of potential negatives:

Limited liquidity: There may be no market for notes if you decide to sell prior to maturity.

Wild pricing: If interim liquidity is available, it may come with prices detached from underlying fundamentals. It would be quite frustrating to have a positive market move that results in a loss for you, nonetheless.

Call provisions: Your bond could be called at a price that was more beneficial to the issuer than you but was also allowed in the prospectus.

Excess expenses: Trading options is quite cheap. The underlying markups to structure them as a “product” rather than a set of trades might come with much steeper commissions than if you or your advisor knew how to structure such a trade.

Bitter taxation: Bonds pay interest, and the “coupon” of the ultimate return in a note would normally be taxed as such. Underlying price movements are normally considered a “capital” event with much lower capital gains taxation. Thus, a note could actually convert “capital” to “interest” and potentially double the applicable tax rate.

Credit risk: You would not have wanted to own Lehman or Bear Stearns notes in 2008, even though the underlying derivatives might have done fine.

Inopportune caps: The history of capital markets may show returns of 9% annually, but the ranges can be dramatic. It takes every ounce of upside to make the numbers so compelling over time. When you cap your returns at, say, 15% and a surprise 40%+ year occurs out of nowhere, the math of your note might be awful.

Creates direct conflicts of interest:  It’s one thing to have Merrill Lynch recommend the purchase of Exxon shares. It’s quite another to have Merrill recommend its own notes where they have a direct financial interest, whereby potentially good outcomes for the investor are bad for Merrill and vice versa. 

These are just a few of the many considerations. In the final analysis, the investor who consistently applies risk for the longest time wins the game of both returns and taxes. Gimmicks like structured notes and index annuities might make the math seem compelling but will likely cause harm in the end.

Please see IMPORTANT DISCLOSURE information.

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