There are various types of structured products in the marketplace. They typically consist of an underlying security, “basket” of securities, commodities, indexes, etc. The underlying security/securities are linked to a derivative product, usually an option. Other structured products track a market index such as the S&P 500 and pay interest to the investor at a specified rate and interval until the maturity date listed or call date. Many structured products will pay a set rate of interest for a fixed period of time and then reset to where the market index being tracked. Structured products also usually have a call date which is generally a year from when the investments are offered. Having a call date or call feature enables the institution issuing the structured product to hedge its bets by calling the product away from investor if the interest on the notes stays too high.
Issuers describe structured products as “principal protected” and suitable for most investors. If they work properly, the investor should receive the return of her principal investment with some degree of return on that amount. Most structured products also offer a substantially higher rate of return than other fixed income investments, such as corporate or municipal bonds or certificates of deposit.
Structured products are generally issued by large institutional banks such as Barclays or Bank of America and are typically backed by the revenue and credit strength of the underlying financial institution. Thus, for a structured product issued by Barclays, the underlying rating would be A- making the safety of principal for the investment appear strong.
These products also offer retail investors the opportunity to invest in derivatives or speculate on the direction of an underlying market index such as the Dow Jones industrial average or the LIBOR rate.
Other common structured products are collateralized mortgage obligations (“CMOs”), collateralized debt obligations (CDOs”), mortgage backed securities (“MBSs”) and credit default swaps (“CDSs).
Of course, any investor should realize that these are necessarily complex investments and many carry the potential to have an interest rate that drops to zero. Any investor considering purchasing a structured product should be fully aware of the risks and features, such as
- These products are highly customized and investors do not realize the full extent of profitability until maturity or if the bonds are called away from the investor.
- They are very illiquid investments with a very small market meant to be held for the long term. It is very difficult to sell these investments in the secondary market at their ask price.
- These investments represent the unsecured obligations of the issuer. Therefore, if the issuer becomes insolvent or files for bankruptcy, most likely the structured product will also default on interest payments and the investor may also potentially lose underlying principal invested.
- The biggest risk posed by these products that most retail investor fail to comprehend is that the above market interest rate initially offered is temporary. This “sweetener rate” lasts for set intervals generally the four to eight market quarters and then resets to a number based off a complex calculation generally connected to some market index.
FINRA has offered guidance to broker dealers selling structured products to retail investors. The guidelines from FINRA include verifying a client’s risk tolerance and investment experience. Financial advisors offering structured products have also been instructed that to avoid any miscommunication about the inherent risks of a variable rate structured product. The broker should explain to the retail investor what the notes would be reset to if the reset date was today. Broker dealers are also encouraged to carefully screen each structured product in house before offering the investment to retail investors, have brokers remind customers of the fact that interest on the products may be zero, and reiterate this information on documents the client will receive, such as trade confirmations.
Structured products can be suitable for certain investors who are willing allocate assets into riskier investments. As mentioned above the most essential thing for retail investors to understand is that the interest may reset to zero and that the products are recommended as a long term hold.
These investments, originally designed for institutional investors, are very complex. Investors should proceed with caution in purchasing these securities.