Introduction
Structured
notes are increasingly becoming choice of alternative investment strategies for
investors who are not able to generate required yield from traditional
investments that include stock, bonds and mutual funds. These notes synonymous
to their name provide customized (“Tailored”) returns on the investment with
accompanied risk. This kind of customization results sometimes increased
complexity and becomes difficult to comprehend for a naïve investor. To alert
investors of potential risks and features of the structured notes, The SEC’s
(Securities and Exchange Commission) office of Investor Education and Advocacy
has issued an investor bulletin investor bulletin.
In this note, Investor will be introduced to the details of
the investor bulletin that includes,
·
Risks and features of the structured notes
·
Key Questions to be asked
·
Examples
Risks and Features:
“Structured notes are securities issued by
financial institutions whose returns are based on, among other things, equity
indexes, a single equity security, a basket of equity securities, interest
rates, commodities, and/or foreign currencies. Thus, your return is
“linked” to the performance of a reference asset or index. Structured
notes have a fixed maturity and include two components – a bond component and
an embedded derivative. Financial institutions typically design and issue
structured notes, and broker-dealers sell them to individual investors.
Some common types of structured notes sold to individual investors include:
principal protected notes, reverse convertible notes, enhanced participation or
leveraged notes, and hybrid notes that combine multiple characteristics.”
SEC
provides guidance with respect to some research that an investor should
consider doing before investing in the structured notes to clearly understand
the risk return profile of the investment. Investor should consider the
questions to understand the dynamics of the note. In some cases they are better off taking help
of an investment professional.
How to locate the information to understand the dynamics of
the note before investing:
Structured
note issuers provide information pertaining to the terms of the investment,
risks associated, payoff performance and initial estimate of the price in their
prospectus. Investors should either peruse the prospectus or seek advice of an
investment professional to get clear understanding on the note. Table below
describes a check list of the information per SEC and where to locate
corresponding information on the prospectus.
Regarding
the SEC Structure Note checklist, the following will describe where the
information can be found in the two example notes.
Examples and Description
The preface to the location of information in the note should
be that there is no strict standard format for the layout of a Structure Note. In
the case of our two examples, MS
and UBS,
the layout of information is mostly similar in the first two pages.
Check
List
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What
is inside the note?
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Location
in the two example notes?
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What are the fees and other costs
associated with the investment?
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Fees
and commissions are costs of manufacturing structured notes and will increase
the cost of the note to the investor. Investor should look into the terms
sheet for this information
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Usually in the
bottom of the first page clearly labeled as Agent’s Commissions or
Underwriter Discount in the case of our two examples. But for other issuers
this information is right next to Issue Price to Public or Price to Public.
This is all dependent on the issuer jargon.
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How much above an issuer’s
estimated value of a structured note will I be paying for the structured
note? Do I know the issuer’s estimated value and its relevance to my
investment decision?
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Structured
notes will carry issuer’s estimated value. This value includes cost of
manufacturing the note. For example, notes that have longer maturity will be
valued at discount due to the time value of the principal of the note.
Understanding this aspect of difference between the initial value of the note
and investment will help the investor to understand true cost of the
investment.
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As mentioned above
this is found on the bottom of the first page, in our examples as, Issue
Price to Public and Price to Public.
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How do I know whether this product
is appropriate for me given my overall investment objectives?
Structured notes may not be a suitable investment for you. You should
review your investment objectives and tolerance for risk with your broker or
financial adviser before you consider investing in a structured note.
They can help you determine whether the risks associated with a particular
structured note are within your tolerance for risk, or whether your
investment needs are better served by investing in another product. Your
broker must only recommend securities transactions and investment strategies
for your brokerage account that are suitable based on your investment
profile.
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Investment
policy statement based on the risk appetite and tolerance of an investor will
guide the investment decisions. Investor should clearly understand how to
clearly customize risk reward profile to increase return and reduce the risk
based portfolio optimization approach. Portfolio optimization provides guide
posts for an investor who wants to increase his investment spectrum in the
mean variance space. Structured notes with their tailor made risk and return
profiles can be structured according to specific set of risk preferences.
Investor should speak to their broker or an investment professional to
understand the risks in the investment.
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This is a little
tricky since the suitability is determined by investor’s risk appetite. But
in the two examples there is a section called risk factor. This section is
used by issuer to point out and explain what types of risk this note
accompanies.
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What other investment choices are
available to me? Are other products available that provide investment
exposure to similar assets, indices or strategies? If so, how do the
costs of these other products compare to those associated with the structured
note? Carefully consider what might be a suitable investment for you, and
whether there are better alternatives to the structured note you are
considering. For example, can I purchase some or all of the components
of the structured note separately for a better price?
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Structured
notes are very specific and customized investments. An investment
professional or professional investor can deconstruct and replicate the
payoff structure for many of these notes using other traded instruments. In
some cases it is not possible. Investor should understand the price of the
note separately in terms of its components and compare it with note price.
Investor should consider taking help from the investment professional.
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How long will my money be tied up?
Many structured notes are meant to be held to maturity. If you need your
money back prior to maturity, you could lose a significant portion of your
investment.
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Traditional
investments (stocks/Bonds/ETFs) can be bought and sold on any day and time on
the market. They don’t come with any kind of preset maturity. On the other
hand structured notes will have maturity term and investment will be locked
till that point in time unless the issuer calls the note or the investor puts
back the note. This feature will potentially lock up the money for a period
of time. Investor should understand their needs and discuss with their broker
or an investment professional.
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This information is
available in the Final Terms( or sometimes called Key Terms) on the first
page. In our UBS case, it is labeled as Maturity Date, Jan 24, 2017. For
Morgan Stanley, it is labeled as Maturity Date, Jan 20, 2017.
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Can I sell or otherwise liquidate
my investment before the maturity date? A liquid market for structured notes
does not exist. If you want to sell your structured note before it matures,
you might have to do so at a price less than the amount you paid for it, or
you may not be able to sell it at all.
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As
mentioned above traditional investments are liquid investments. You can
transact in them easily on the market. Conversely Structured notes are thinly
traded. Selling them before maturity will often carry penalty (by the issuer)
and due to illiquidity it will become difficulty to sell.
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This information was
not available in the two example notes but might be available in other notes.
There might also be information on this in the product supplement.
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Is there a call feature? If so, be
sure you understand what can trigger the call and the earliest date that the
structured note may be called. You will also want to ask your investment
professional about a strategy in the event your structured note is called.
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Call
feature is a novel aspect of the structured note that enables an investor to
exit the investment under certain favorable or unfavorable investments. Usually
call feature will increase the yield of an investment. Notes like Auto
callables will mature automatically when the note underlying reaches certain
preset level before maturity. Investor should speak to an investment
professional about the embedded call feature.
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The Note features
are indicated in the subtitle of the note. The Morgan Stanley example
indicates the features of the note being a Contingent Income Auto-Callable.
The UBS examples shows it is a Trigger Autocallable Optimization.
Further explanation
of the note features are provided by Morgan Stanley in the Investment Summary
section in page three.
In comparison to the
UBS example, which indicates a trigger price in the Final Terms.
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Are potential returns limited? Some
structured notes have caps on the returns you can earn based on the
performance of the reference asset or index
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Investors
should understand if the note provide limited or unlimited returns. This will
help in evaluating the investment compared to other investment alternatives.
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This information is
usually given under the section called Hypothetical Examples.
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What are the tax implications? You
might wish to consult with a tax advisor to understand the consequences of
any particular structured note, including imputed interest and any foreign
tax consequences.
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Every
investment has tax implications and structured notes are no different. Infact
on the term sheets issuers provides guidance to what is taxable and what is
not cursorily. Again investors should speak to an investment professional on
this aspect.
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The tax implication generally
nested deep in the note. In the Morgan Stanley example it starts on page 18
and continues to page 22.
However the UBS
explains that the tax information can be found in the “What are the Tax
Consequences of the Securities” and “Supplemental U.S. Tax Consideration” in
the UBS Trigger Phoenix Autocallable Optimization Securities Product
Supplement (TPAOS).
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How does the payoff structure work?
Is it possible to lose money, or not have any gain at all, even if the
reference asset or index goes up? Purchasing a structured note does not
guarantee positive returns. For example, the reference asset or index might not
increase in value—or even if it does, there may be conditions that limit your
returns.
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Structured
notes are created with a variety of payoff structures. Some have principal at risk that is you
might lose a portion or all of the initial investment. Therefore investor
should understand how the payoff structure works. Investor should seek help
of an investment professional in this regard.
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This information is
usually given under the section called Hypothetical Examples.
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What is the credit risk of the
issuer of the structured note? Remember that any payoff on a structured
note is subject to the creditworthiness of the issuer. Be sure to
understand the financial condition of the issuer and read its disclosures as
carefully as you would for any other investment.
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Structured
note issuer guarantees the payment of the principal and coupons as per the
terms of the investment. Sometime due to deterioration of the financial
condition of the issuer will lead to default on the note by the issuer.
Therefore investor should understand the creditworthiness of the investor.
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This information is
found in the Risk Factor section and used to explain how the issuer is at
risk to the Structure Note.
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Do I understand the
investment? Many structured notes are complex. If you do not
understand how the structured note works, ask your investment professional
for help. If you still do not understand the structured note, you
should think twice about investing in it.
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Structured
notes are in general have payoff structures that are complex and needs an
investment professional to analyze them. For instance digital payoffs and
basket payoff involve binary events or correlations between the underlying
entities. So investor should seek help of an investment professional
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As the SEC
recommends it is best to ask your investment professional for help. But if
you want further information, the notes include a hyperlink for a Product Supplement
as well as a Prospectus.
Both of our example
notes show it in the Additional Information section. For the Morgan Stanley note this section is
all the way in the bottom of the note. But in the case of the UBS note, this
is right under the Final Terms.
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