What to Know About Structured Notes

Fish and Fowl Today's column is something different. Rather than advance an argument, as this space customarily does, it describes an investment type: structured notes. Normally, I leave investment descriptions to others, assuming that my readers already understand the basics. But structured notes are both obscure and imperfectly served by the standard reference sources.

Structured notes are, in effect, a bond/stock hybrid. (Actually, they can be a bond/anything hybrid, but for simplicity's sake let's restrict ourselves to the common application.) As with a bond, structured notes have a fixed maturity date, they may (or may not) pay coupons, and they repay principal upon maturity. However, the amount of that principal varies, depending upon the behavior of a stock (or stock index, or basket of stocks).

Restructured Apple Here's a real-world example.

• No yield.
• If Apple's stock is higher at maturity date than when the note was issued, the investor receives 100% of the original principal, plus 110% of Apple's subsequent gain.
• If Apple's stock is lower at maturity date than when the note was issued, but its decline is 25% or less, the investor receives 100% of the original principal.
• If Apple's stock is lower at maturity date than when the note was issued, and its decline proves to be greater than 25%, the investor loses principal in proportion to Apple stock. That is, if Apple's stock price fell 37% during those three years, then the investor would receive 63% of principal on the payout date.

(This seems like a deal too good to be true! The buyer earns leveraged upside on Apple stock, with no cap on the gains, while enjoying some downside protection. However, the investor does pay a cost for those features, by forgoing Apple's dividends and because the downside protection is time-dependent. It engages at only one time, on the security's maturity date, which means that investors who wish to trade in the interim do not enjoy the protection.)

You might be wondering where the "hybrid" is with that particular note, which does offer some principal protection but carries no coupon. However, that is but one form of structured note. An alternative might be a three-year security, also based on Apple stock, that carries a 7.75% annual coupon. Under most conditions it will behave as a souped-up corporate bond, boasting a high yield and full principal repayment on maturity, but if Apple stock performs badly enough the principal will be reduced.

Pros The advantage of structured notes is obvious: They can do what the buyers wish. For one, they afford the opportunity to purchase a risky asset, with those risks substantially reduced. Structured notes don't eliminate the possibility of getting well and truly clocked; if a stock performs badly enough, the structured-note holder will also suffer. However, structured notes can and do guard against moderate losses. Of course, this protection doesn't come for free--the cost of such insurance comes from conceding some potential gains.

Structured notes also can turn capital-appreciation assets into income vehicles. Apple currently yields 1.5%. That doesn't make its stock inaccessible for retirees who seek ongoing income, but it does complicate planning, because if Apple stock doesn't pay enough to live on (which it probably does not), then either capital must be raised, or other portfolio assets must have high yields. Obtaining Apple exposure through an income-oriented structured note could be a solution.

Another way of thinking about the issue: In today's marketplace, where equity dividends are low, stocks and bonds accomplish very different tasks. Stocks almost exclusively deliver the promise of capital growth, at the expense of safety and income. High-quality bonds have little possibility of capital growth, somewhat more income (although current yields are relatively low), and much safety. Most investors want something that lies in between those two assets. They can do so by combining stocks and bonds, or perhaps they can do so directly via structured notes.

Cons Those are structured notes' strengths. Onto the weaknesses.

To date, structured notes have primarily been sold by banks, to either institutions or their personal-wealth clients. This approach has had two effects. One is that structured notes have operated in near-secrecy. They are not publicly traded securities, listed on exchanges, about which information from the SEC's databases is readily available. They are privately offered issues. If you want to learn about a structured note, you'll have to hunt down its term sheet.

The other is that the United States is a follower rather than leader in structured notes, because banks in the U.S. have a relatively paltry share of securities sales compared with the rest of the world. Of the roughly $3 trillion invested in structured notes globally, only about $400 billion resides within the U.S.

For structured notes to become a meaningful investment segment in the U.S., they need a jailbreak. They need to be distributed by parties other than banks and for their information and trading to be centralized. Currently, the structured-note investor is largely at the mercy of the bank that originates the issue. The bank prices the security at launch as it sees fit, and should the investor wish to trade the structured note before it matures, the bank (or perhaps one of its competitors) also determines the bid. The structure-note marketplace is closed, rather than open.

Breaking Free As part of that jailbreak, structured notes require more transparency. They are admirably up-front about their investment details. Their term sheets provide all the necessary details about the payoff schedules; one can use that information to model precisely how the structured note will behave in response to changes in the stock's price. But they are silent on expenses. There is no practical way for the structured-note owner to understand whether she has received a fine deal, with the bank accepting low margins, or if she has been fleeced.

(There is an impractical way: attempting to duplicate the creation of that structured note by finding the prices of the zero-coupon Treasury notes and stock derivatives that are used by the banks to deliver the promised return stream. But that tactic, shall we say, is for highly informed purchasers only! (And even so, it is incomplete, as when pricing the structured note, a bank uses proprietary data investors don't have access to.))

Summary

1. Structured notes behave something like bonds and something like stocks.
2. Their hybrid qualities could make them very useful in a portfolio.
3. They can easily be customized, to meet a variety of needs.
4. However, because their market is decentralized and lacks transparency, particularly with regards to expenses, structured notes have struggled to gain ground in the U.S.
5. Their struggles will continue until item number 4 is fixed.

I expect that marketplace centralization will occur. The problem lends itself to technology. Perhaps this long-quiet marketplace will begin to emerge from the shadows.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.