A new trend in investing is structured products. They are structured notes or Structured CDs that use the term “CMS-Linked” and refer to structured note investments that are linked to Constant Maturity Swap (CMS) rates. These are unique securities that have been gaining a lot of investors in the past years. These are often bundled and referred to as structured products.
What makes them a unique form of security over other options is they are constituted of both component and embedded directives. The investment strategy is very complex and considered a higher risk that has led to major losses by unsuspecting investors. The debt instrument was often sold to prospective investors as a fixed income investment without a liquidity risk.
Adding to the complexity of these products is the fact that many of the CMS-Linked notes sold to investors have a coupon rate that depends on the CMS rate for a long maturity and the CMS rate for a shorter maturity and the difference or “CMS spread” between the two rates.
Overall a product that is extraordinarily complex often adds additional features such as STEEPENERS or Autocallable Reverse convertible features. These features add to complexity (and are often more profitable for the issuer).
Investors need to know that these securities will only perform depending on the reference asset, exchange traded funds (ETF), or index they are linked to. The main linking options include individual equity, commodity, currency, equity index, and even interest rate. Here we shall assess the meaning of structured notes, structured products, the different types available, how they work, and how investors should interpret the same.
There are three main categories of securities which include derivatives, debt, and equity. Structured notes are hybrid investment instruments since they are made of two components which are the debt component and the derivative component.
Examples of structured notes include principal-protected notes, reverse convertible notes, and leveraged notes. Most securities are defined by the type of category they fall in and that includes debt, equity, and derivative categories.
At Haselkorn & Thibaut, we have recently received calls from investors that invested capital in structured products that are looking at substantial losses. Most of the investors did not understand the investment strategy, risks involved with structured products, issuer credit risk, and underlying asset. Investors can call our experienced lawyers at 1-800-856-3352 for a free consultation on recovering losses.
CMS Structured Financial Instruments
CMS rates with a “multiplier” or “Leverage Factor” can also add further complexity. However, for most investors, they are at a loss as to how to understand the basic features never mind future changes that may be impacted by the steepness of the term structure of interest rates. Issuers added to the complexity of these products in a manner that makes it more complicated for investors to understand the anticipated floating rate coupons when those floating rate coupon rates are also contingent upon various stock market indices.
In some cases, the floating rate is only triggered and paid if three separate indices all close at a particular value on the pricing date. If only one index missed the trigger, the floating rate coupon rate is missed and lost.
The CMS-linked notes are an asset purchased by an investor and a liability owed by the issuing firm. When these notes are callable, it is typically a feature triggered when the notes are more valuable to the investors and more costly to the issuers and the issuer seeks to call or redeem the securities.
The deck is stacked here and a feature that sounds like more bells and whistles is actually a feature that only typically works against the investors and leaves the investors holding notes that are comparatively less valuable to investors and more costly to the issuer. This of course is in addition to spot rate risk, the term structure risk, the market risk, the illiquidity risks (as there is really no secondary market for these products and early sales usually involve sharp discounts), and credit risk.
In products that add reverse convertibility, the contingent floating rate coupon will typically be equal to a multiple of a CMS spread and tied to the worst performing of two or more stock indexes. The investors typically are not understanding future changes in two or more stock market indices as well as the variance or covariance of the specified stock index. This generally requires a complex interaction of multiple indices, and how the average investor can realistically choose between competing for similar products is a mystery.
For CMS-linked notes with complex embedded contingent interest rates and stock index options, which, when triggered, reduce the coupon and maturity payments, most investors are trusting their financial advisor from the outset.
The largest issuers of these securities are Citigroup, Morgan Stanley, Goldman Sachs, Wells Fargo, Royal Bank of Canada (RBC), Barclays, Bank of America, Credit Suisse BMO, and JP Morgan.
History of structured products and notes
Initially structured products and notes were a privileged investment that was only made by the wealthy through private banking institutions, however now accessible to anyone interested, thanks to the improvement in technology over time.
Most firms and banking institutions issue notes to interested investors, thanks to the growing global market of the same surpassing $3 trillion. They were however born in the 1970s, first in Europe before spreading to other countries around the world including Switzerland and Germany.
Types of structured notes and structured products
The price and returns of structured products vary from time to time and are determined by the existing market variables. Structured notes investors are able to participate in upside movement if they wish and also get protection against negative price movements in a worst-case scenario. Find out the different types of notes options that most issuance firms deal with.
These are often availed as coupon payments to investors and work almost similarly to traditional bonds. They can be customized and are also made to suit the diverse market sentiments. Income notes can be used as core portfolio holding mainly meant for income. It can also be perfect for use replacing holding an index or basket of stocks in the equity allocation process. Some investors choose to look at them as tactical investments where one gets better ROI than core notes besides the extra downside protection you are shielded against.
A growth note is a type of structured note that gives you the investor chance to participate in upside performance of the assets underlying for your note. It is tied to a series of positive performances from the assets tied while limiting potential downside exposure. Tradeoff in this case will come down to balancing the upside potential with the downside exposure using means like soft and hard protection. With soft protection, one can enjoy greater participation on the greener side whereas hard protection is for those who want comfort against downside risks which makes it perfect for conservative investors in the market.
They are also referred to as Dual Direction or Absolute performance notes. It is unique because it permits the investor engage in positive performance of the assets tied to their structured notes. The best part is in how there is a limited amount of negative performance for the same assets which is what most investors are interested in. This negative performance part is also capped at a specific participation level but it all depends on the downside participation used. Your payment as an investor will be determined by the final price of the underlying assets at the time of maturity.
In other parts, it is also called Step Payment and works almost similarly to income notes with the only difference being how the coupon payments are handled. In digital notes, you should expect a single coupon payment once your note has matured. Initially, some note plans entailed getting coupon payments at fixed intervals as you await the maturity of the note you possess.
Principal protected Notes
These are structured products that are connected to the market but offer the investors full principal protection when losses are imminent. The issuing institution will incur the credit risks and hence investors have no demerits to it, all thanks to the market-linked return guarantee offered. It is an ideal option for you if you are a risk-averse type of investor.
How structured notes work regarding the underlying asset
From the details above you will notice that structured notes only work based on how the securities lying underneath them function. The time on structured products is limited which means they will reach a maturity period. Any kind of returns earned on structured notes is a derivative of the performance of other assets.
You should expect the structured products to depend on the equity index for its returns which is all based on how the index performs. What you also need to know concerning the investment is that besides being attached to the equity index, it can also be linked to single-equity security or foreign currency.
Are structured products unsecured? Yes, they are, because the institution issuing them will not have pledged any kind of assets to be used as collateral for the same. This goes a long way to affect the payout because the quality of ROI will be determined by the financial strength of the issuing firm.
The worst case scenario is if the issuing company goes ahead to default on the same which may translate to major losses to the investors. Since these notes are complex securities, different firms have varying details when it comes to the same. The case is the same with pay structure that will be advised for you depending on the issuing company that you choose. Some of the key components of payoff structure regardless of the issuing firm include the following highlighted below.
This is the first component of the payoff structure most issuance firms will let you know. It features permission to allow for cutting of the returns on the structured note in the event that the value of the underlying assets drops past a predetermined value. It can both be a merit and a demerit depending on how the underlying assets perform.
Principal protection guarantees you a portion of your principal back no matter the outcome of the performance of underlying assets to the structured products this is the benefit of taking investments that have principal protection for the potential situation when the underlying assets lose or depreciate in value. Depending on the firm you choose to get your structured note from, the principal protection might have different names, for instance, minimum return, absolute return, and even capital guarantee.
Capped maximum returns
This is a unique option where the structured note is set at a limit of the stated cap to determine the ROI. This means that a capped maximum return that is predetermined is used on your note. It is a great option but not when the underlying assets increase in vale past the capped maximum return. This means you will only be able to benefit as per your capped maximum return amount. This means only getting 20% caps even when the value of the assets underlying have increased past 35%.
There are many issuing firms whose payoff structure includes participation rate benefits. This also means that at the minimum what you get as ROI includes fixed percentage of the increment in value of underlying assets inclusive of your principal. This is also an option that a lot of investors find ideal especially when the underlying assets whose performance determines their ROI improve in value.
What new structured notes investors should note
As you already know from the above guide, structured notes are not so easy to understand at the start when you are investing. This is why first time or amateur investors are asked by experts to pay more attention to detail and caution as they weigh their investment decisions. You first have to determine the issuance firm you want to get structured notes from and then the underlying assets whose performance determines the quality of your returns. You can best make this decision after you successfully determine the correlation between your structured note and how it relates to the reference assets to predict the possible future.
When looking for the right structured products issuance firm to use, you will be surprised that not all of them have all the components of an ideal payoff structure as they may miss participation rates, knock-ins and capped returns among other useful features. Such firms include EFTs and even mutual funds where some investors choose to go without considering the effect of the decision on the quality of the returns they get on the investment.
One last thing investors should note is that the liquidity of the notes is lower than that of other assets or investments. Since the notes are not for trading on exchanges, investors will have to wait until the maturity of the note before they can get their returns. For some investors, this is never ideal because of the inability to access any percentage of funds from their investment, especially when they have an emergency before the maturity date of the structure note. It might be of benefit to consult widely with professionals and successful investors besides doing your own research to establish whether or not investing in structured notes is the right move for you.
Four factors to consider when choosing structured products
Maturity of the structured notes
You can choose structured products or institutions issuing them based on the actual date of maturity indicated for the options you have. The duration of a structured note can vary from a short-term investment of 6 months to a long term investment of more than 15 years. The average notes investor today however happily invests in structured products whose maturity period takes between two and five years.
You definitely know that as an investor your ROI will depend on the performance of the referenced assets tied to your structured products. There are different types of assets that can be attached to your structured note and you only have to make a choice after you research all of them. Some of the asset options include indexes, stocks, commodities, foreign currency, and even groups of stocks. You can only make your decision after you are well informed of the potential increment in the value of the underlying assets.
Return on investment
This is the amount investors are supposed to get after their structured products have matured. The return on investment will be determined by whether the assets underlying the structured note improve in value. There are two types of payoff structures that include income and growth which cover the majority of note types. The income payoff structure will give investors a fixed return level that comes with periodic coupon payments. For the growth option, investors get upside participation on the referenced assets. From consideration of all the variables, investors can create the right note to fit their objectives.
Did you know that there is an amount of your investment that has to be protected against risks like price decline for the assets that are attached to the notes that you have invested in? The parameters of the protection are as long as the value of the underlying assets has not depreciated further down than the protection amount. In any case, you need to get your principal back but it depends on whether you choose hard or soft protection against losses.
Implementation of Structured products
Through the use of the laddering process, investors are now able to manage maturity dates for their structured notes while alleviating the timing risk when the maturity period comes. Laddering is a strategy that entails diversifying your portfolio which works perfectly with structured products and bond investing. For security against market volatility, you should consider spreading out structured note maturities considering the performance depends on the price of the underlying assets at the time or date of maturity.
Investment Loss Recovery of Structured Products
A sad trend we are seeing is that many investors of structured products are completely unaware of the risks. Market conditions have led to historic losses in these types of investments.
At Haselkorn & Thibaut, we have recently received calls from investors that invested capital in structured products that are looking at substantial losses. Most of the investors did not understand the investment strategy, risks involved with structured products, issuer credit risk, and underlying assets. Investors can call our experienced lawyers at 1-800-856-3352.