Structured Notes Investing – Checklist

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	What is inside the note?	Location in the two example notes?
What are the fees and other costs associated with the investment?	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	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.
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?	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.	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.
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.	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.	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.
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?	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.
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.	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.	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.
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.	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.	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.
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.	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.	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.
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	Investors should understand if the note provide limited or unlimited returns. This will help in evaluating the investment compared to other investment alternatives.	This information is usually given under the section called Hypothetical Examples.
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.	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.	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).
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.	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.	This information is usually given under the section called Hypothetical Examples.
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.	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.	This information is found in the Risk Factor section and used to explain how the issuer is at risk to the Structure Note.
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.	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	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.