Market-Linked Structured Notes With Principal Protection

From the Desk of Jim Eccleston at Eccleston Law LLC:

Market-linked structured notes with principal protection (also known as “Structured Notes”) are very complex securities that are gaining traction in the retail market. Structured notes often are characterized as an investment vehicle that combines a zero-coupon bond with an option or other derivative whose payout is linked to an underlying asset. The underlying assets range from market benchmarks, foreign equity indices, currencies, commodities, interest rate spreads, or hybrid baskets of various asset types. For example a structured note could be tied to the performance of a weighted basket of the S&P 500, an ETF tracking real-estate, the Euro-USD exchange rate, and the price of gold.

Because structured notes are tied to the performance of an underlying asset(s), they may be able to outperform the traditional interest payment that would be paid on typical fixed interest rate bonds. However, they are also able to underperform, and this could lead to zero return for the entire term of the note, which may be 10 years. Moreover, the performance of the underlying asset(s), is largely determined by the issuer, who is able to dictate performance metrics and thresholds.

It is very important to evaluate carefully and thoroughly the performance metrics in consideration of a structured note. First, there are many complicated ways to measure market-linked gains (or losses). The range of structured note products each delineate precise times of performance measurement. Some compare the asset at two discrete points in time while others may look at the index or asset value at annual anniversaries and then compare the highest value with the value of the index level at the start of the term. No matter what the performance metric, it is crucial that both the advisor and investor are aware of the schematics of the structured product.

In addition to performance, returns on investment in structured products may also be tied to participation rates. In most cases, the participation rate determines how much of the gain in the underlying asset can be attributed to the note held by each particular investor. For example, if the participation rate is 50 percent, and the underlying asset increases by 10 percent, the return credited to the note would be 5 percent.

Also, structured products have various minimum guaranteed returns on principal. When analyzing these products make sure to understand how the issuer defines the term “minimum guaranteed return.” Sometimes, the term includes both the principal guarantee plus a fixed overall investment return. For example, a note with 100 percent return of principal at maturity and a 3 percent minimum guaranteed return would pay the holder of the note 103 percent of the initial investment at maturity regardless of the performance of the underlying asset. Other times, the term only may refer to the initial investment.

Another concern with structured investments lies in the liquidity or lack thereof. Because these investments tend to be longer term, tying up your money for several years, the investor could be stuck with the investment for longer than desired. Although some issuers allow early redemption, this almost always is subject to significant discounts to the purchase price. Moreover, the secondary market for structured notes also is subject to discounts. In addition it is often difficult to calculate the value of structured notes for resale in the secondary market due to the complexity of the underlying assets that may be subject to prevailing interest rates and the volatility of the underlying assets.

Investors in structured notes also are cautioned about call risk. Call risk refers to the possibility that the issuer could redeem your note before maturity depending on the terms of the note. In most cases, the issuer will choose to redeem or call the product at the issuer’s time of best interest rather than the investor, such as when interest rates fall.

Structured notes, like many investments, are subject to hidden fees, even when sales materials suggest otherwise. These can include selling commissions or concessions, management fees, structuring fees, early redemption fees, or some other type of fee delineated by some other term. Fees incurred often stem from the way that the product is bundled or packaged. Those hidden costs make it possible that the investor could have assembled the same bundle of products at a lower cost. The maximum return of structured notes with principal protection will often reflect the cost of manufacturing and maintaining the note and those cost generally are not transparent to the investor or advisor.

Thus, it is very important for investors and advisors to understand that structured notes have complicated pay-out structures that can make assessing growth potential difficult. Furthermore, the issuer’s terms make it possible that the investor holds the note for upwards of ten years with the return of simply 100% at maturity. And it is important not to forget that the credit worthiness of the note is only as strong as that of the issuer. In the event of a bankruptcy, the investor could lose the entire investment, regardless of minimum guaranteed returns.

In the end, adequate time and caution is essential for both the adviser and the investor before considering an investment in structured notes with principal protection.

 The attorneys of Eccleston Law LLC represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 65 years in delivering the highest quality legal services. If you are in need of legal services, contact us to schedule a one-on-one consultation today.

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