Are structured products worth a look for worried clients?
“We’re using structured products to reduce risk in clients’ portfolios,” says Michael Faust, vice president of investments at the Faust Boyer Group of Raymond James in Greer, S.C. “These investments can help on the equity side and especially today on the fixed income side. Among our clients there’s extensive worry that interest rates will rise in the future, reducing the price of bonds they own.”
Structured products are alternative investments that can help alleviate such concerns. They’re designed to offer both the potential for substantial returns as well as some downside protection.Nevertheless, structured products have risks as well as complexity so they merit careful explanation to suitable clients.
Often, structured products are notes, perhaps bank CDs or corporate issues. The ultimate payout, though, may be determined by the results of equity markets or some other asset class such as commodities.
CALLABLE YIELD NOTES
According to Faust, “callable yield notes” can serve as bond surrogates, offering a worthwhile combination of income and safety. “They’re usually issued for less than three years,” he says, “with an attractive yield for that maturity, paid quarterly. The downside is linked to two stock market indexes, such as the S&P 500 and the Russell 2000.”
These notes have a “knock-in” price,” Faust explains. That might be 25%-30% below the current price. With a 30% knock-in, for example, a 36-month note bought when the S&P 500 is at 1900 would have a knock-in of 1330 (70% of 1900). If the note is linked to two indexes, the knock-in becomes effective if the worst performer is below the knock-in level on the maturity date.
If the S&P 500 is the worst performer of the two indexes, down 40% on the maturity date, investors would get back only 60% of their outlay. However, if neither index is down 30% or more at maturity, in this example, investors would get their principal back, in addition to the coupon interest along the way. “Such notes appear to be relatively safe,” says Faust. “Historically, there have been very few 36-month rolling periods when stock market indexes have been down over 30%.”
Other structured products offer participation in possible stock market gains. Again, the return might be linked to two stock market indexes, with a knock-in promising a return of principal as long as neither index falls by a predetermined substantial amount. “As an example,” says Faust, “the notes might be callable each year if the worst-performing index is up 5% or more. The call price could be 12.5% a year. That could be good for investors if stocks are up, say, 6% but not so welcome if the indexes are up by much more than the gain from the call.”
Thus, there are tradeoffs in structured products that should be explained to clients. One way to clarify an offering is to show the results in various scenarios: if the worst performing underlying index is up 30% you’ll get this, if the lagging index is down 30% you’ll get this, and so on. “While we stress the downside protection to clients,” says Faust, “we’re also candid about the risks—they could lose money with these products.”
The greatest risk, Faust adds, is default, so looking at the creditworthiness of the issuer is the chief concern with these structured products.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.
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