Dangers lurk in structured notes. Structured notes have become very popular with investors. In fact, Wall Street firms like JPMorgan Chase, Bank of America and Goldman Sachs created and sold over $10 billion of structured notes tied to the S&P 500 stock index in 2012. The allure, unfortunately, may be misleading.
These investment products have maturities like bonds but are linked to stocks, currencies or commodities. One of them – JPMorgan’s 18-month Buffered Return Enhanced Notes (BRENs) promises a return of 150% of the S&P 500’s gain as of the maturity date, but investors are hit with 90% of any loss. In other words, investors can lose 90% of their principal (“A Devil’s Bargain Faces Investors in Popular Structured Notes,” Bloomberg).
In addition, the investor’s upside is capped at 14%. Given the stock market’s short-term unpredictability, there are many years when the S&P 500 goes nowhere or suddenly lurches ahead or drops by a significant percentage. Since investors must bear 90% of any loss, a 14% cap is probably not enough of a premium to warrant taking the risk. The S&P 500 rose 16.5% in 2012.
But there is more bad news. Investors in the BREN do not receive dividends that they would if they owned an S&P 500 stock index fund. That is significant. The dividend yield is 2.2 currently on the average stock, and dividend yields comprised 40 percent of investors’ total returns historically.
There is also the problem of credit risk. The structured notes are unsecured obligations of the issuing bank. As investors in the supposed “100% principal protection” notes issued by Lehman Brothers discovered, when Lehman went bankrupt, the notes became almost worthless overnight. Safety conscious investors were suddenly left with nothing but unsecured claims in the bankruptcy.
Last but not least, structured notes are highly illiquid, meaning they are automatically unsuitable for investors who may need to access their capital prior to the maturity date.
This information is almost certainly not fully disclosed to potential investors, because no one in their right mind would think: 14% upside cap, 90% downside risk, no dividends, possible 100% loss of principal if the issuer goes under like Lehman did, illiquid investment – now that’s for me.
Unfortunately, these structured products are generally pushed by selling brokers, not asked for by investors. Brokers have an incentive for being less than forthcoming about the risks of structured notes. This incentive is the selling commissions of 1.5 percent for an S&P 500-linked note and up to 10 percent for more notes tracking more exotic indices.
These upfront commissions are not transparent to investors because they are initially paid by the issuing bank and recouped through mechanisms embedded in the structure of the note. Other expenses, such as the cost of hedging and leveraging, are likewise hidden in the structure of the note.
Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.