Structured Products: The Good, the Bad and the Ugly

Feeling nervous about what to do in the market? Structured products appear to provide the answer. Before signing up though, it is best to look at the offering closely.

Reading some descriptions of structured products make them sound almost too good to be true. For example, according to Citibank:

“Structured products such as Structured Notes can offer you the best of both worlds, combining growth potential, with the ability to protect your initial investment provided they are held till maturity and subject to credit risk of the issuer.”

If this statement suggesting upside potential with little downside risk (if the investment is held to maturity and the issuer is solvent) makes you salivate, hold that thought. It may be more hopeful than it is realistic. Here are some cold hard facts.

From HSBC.com

In a nutshell, structured products consist of a relatively safe investment such as an investment grade bond combined with a higher risk asset that produces the potential return. This means that interest from the bond itself is irrelevant in terms of possible gain. It is replaced by the upside potential from the more risky asset. In the illustration above the designated “safe asset” is the bond. The “option” produces the potential return. The option can consist of an index, a security or a derivative.

For example, a sales pitch may run something like this when the option is the S&P Index: “in six years’ time if the S&P index is at or above its opening level, you will get a bonus, which is a percentage of the original investment, in some cases up to 50%.”

This is the good if it happens.

But, what if the S&P drops? Here is where the bad and the ugly come into play. Let’s say the contract designates that if the S&P drops up to X% of its beginning level, you get your original investment back minus the seller’s fee (up to 10% has been reported, but normally lower). Your forfeiture of principal over six years doesn’t sound so nasty, perhaps, but if you figure the loss of opportunity to gain any interest at all on your money, the cost is greater. In fact, inflation alone will almost certainly make your money worth less.

There may also be a clause that says that if the S&P drops more than X%, your original capital is jeopardized depending on the degree of the dip in the S&P below that level. This is the bad.

From The Guardian UK

Another risk is lurking, too: the credit worthiness of the third party that sells the product to your advisor, bank, broker or whomever. If that organization lacks solvency, the problem could be worse — the ugly. Think Lehman Brothers. There could be a partial or full loss of the original investment.

The same thing could happen if the S&P goes down far below its starting level, such as occurred in 2008. Returned principal is penalized depending on the depth of the drop.

This is where reading the fine print of the contract can help, especially if the downside is not explained adequately. The problem, of course, is that often the terms of the agreement are difficult to understand. Sometimes even the advisor, broker or banker’s representative will not comprehend what they are marketing.

So, investor, beware. There is no free lunch except for the seller of the product, who always gets an upfront fee and, possibly, continuing revenue as well. It is the investor who takes the risk.