Are Structured Products Suitable for You?
- Do you want the potential opportunity to earn a higher return than a conventional deposit?
- Are you looking to obtain a risk and return profile not otherwise available?
- Are you looking for more sophisticated solutions to meet specific investment objectives?
- Do you want your returns to be linked to a specific market (e.g., equity, commodity or credit)?
- Are you willing to make investments that may not afford you regular or consistent income?
- Are you seeking to protect your principal investment?
- Are you willing to make investments that in some circumstances offer youlittle liquidity?
Many of our clients answered yes to one or more of these questions and found that Structured Products fit well into their overall investment portfolio.
Benefits and Risks Associated with Investments in Structured Products
- Underlying Risk: The underlying asset (often referred to as simply “the underlying” or “the index”) is the share or shares, share index, currency, commodity, fund or other asset which is used to calculate the return of the Structured Product at maturity can underperform expectations.
- Non-Participation: Investing in a Structured Product linked to an index is not the same as investing directly in the index itself (or the component shares). Although a Structured Product is intended to mimic the performance of the underlying, investors in structured products will not receive dividends or other forms of distribution from the companies in the index.
- Upside Participation: Structured Product investors may also give up a portion of capital appreciation in exchange for principal protection.
- Liquidity Risk: While there is a secondary market for many Structured Products, this secondary market should not be relied on to provide liquidity. Structured Products have a defined investment term, and are intended to be held until maturity. This allows for capital protection and other features, but means they are not suitable for investors who may need to access their money during the investment term.
- Credit Risk: The bank or financial institution that issues the structured product is responsible for paying back the investor’s capital and return at the end of the investment term. Some Structured Products such as Structured CDs carry FDIC insurance protection up to the federal limits and therefore the risk of default does not exist. Structured Notes, however, carry no FDIC insurance and may experience default if the issuing bank becomes insolvent. For this reason, the credit rating of the bank issuing the note and how that rating compares with other banks is important.
- Principal Protection: The principal amount you invest can be 100% protected when held to maturity, regardless of what happens in the markets over the term of the investment.
- Diversification: Structured Products can help an investor establish a well-diversified portfolio by opening the door to a variety of asset classes that may be difficult to access otherwise. This includes global stocks, indexes, commodities, currencies, interest rates or a favorable combination (multi-asset).
- Potential for Income Distributions: Some Structured Products are designed to provide you with income. With these types of Structured Products, you have the potential to receive enhanced income each year based on the performance of the underlying assets.
- Stability: Halliday Financial works with banks that carry some of the highest credit ratings in the US and around the globe. Additionally, in some instances, the Structured Product may be issued by a bank in the form of a Certificate of Deposit and carry FDIC insurance.
- Defined Time Limit of Investment: All retail Structured Products have a mandatory maturity date. The maturities can range from as short as three months to as long as 30 years.
Structured Product Types
Structured CDs enjoy the performance characteristics of other Structured Products plus a federal protection identical to CDs issued by your local retail bank. Protection limits are up to $250,000 insured on savings, checking, and other standard deposit accounts per depositor and up to $250,000 insured on retirement accounts, such as individual retirement accounts (IRAs) and Keoghs.
- Most Structured CDs carry a survivor benefit the terms of which make the CD redeemable by the holder’s heirs/executor at par or current market value in the event of the early death of the holder of a CD
- 100% principal protected when held to maturity
- Potential income predicated on underlying assets performance
A Structured Note is a note that is issued by a large financial institution. They can be registered securities or non-registered securities. Registered securities are filed with the Securities and Exchange Commission (SEC) as medium-term notes. Non-registered securities are exempt from SEC registration and are typically issued by foreign-based banks through their U.S. branch offices using a 3A2 exemption.
Who Issues Structured Notes?
Structured Notes are issued by domestic and foreign banks to help fund their lending programs.
How does a Principal Protected Note work?
In its simplest form a Principal Protected Note (PPN) consist of two components. When constructing a PPN that is linked to an equity index, the issuers invest in both zero coupon bonds and equity call options. First, they use a portion of the available assets to structure zero coupon bonds that match the maturity date and principal amount of the PPN. Unlike regular bonds, zero coupon bonds are issued at a discount to their face value and do not pay interest. This means that issuers can structure a note that will return $1,000 at maturity for an upfront investment of less than $1,000. The difference between the note’s value at maturity and the amount paid represents the note’s implied return.
By investing in zero coupon bonds, the issuers have ensured that the PPN’s investment principal is protected at maturity. Your direct credit risk is limited to the financial well being of the issuer.Because zero coupon bonds are issued at a discount to their face value, the PPN issuers will have excess capital to invest. They put this money to work by structuring equity call options on a broad-based equity index, such as the S&P 500 Index. A call option gives an investor the right (but not the obligation) to buy an investment in the index at a specific price within a specific period of time. The call options typically have an expiration date that matches the maturity date of the zero coupon bond, along with a “strike price,” or entry point, that matches the current value of the index. If the underlying asset (the S&P 500 Index) increases in value, the value of the call option will also increase.
Types of PPNs include:
- Equity Linked Notes
- Currency-Linked Notes
- Commodity-Linked Notes
- Precious Metal-Linked Notes
- Interest Rate-Linked Notes
A Reverse Convertible Note or Reverse Convertible is a structured investment that aims to provide exposure to a specific underlying security, while also providing a coupon payment.
In its typical form, a Reverse Convertible consists of a principal component linked to a performance component, typically equity securities.
Reverse Convertible Notes are issued by banks, and they are subject to the creditworthiness of the issuer. The notes themselves do not carry ratings. The investor’s credit risk is dependent on the credit rating of the issuing bank.
The Notes may be linked to common stocks, American Depositary Receipts (ADRs), baskets of stocks, stock market indices, commodities or other asset classes. The primary feature of a Reverse Convertible is its enhanced yield. The Note is intended to pay a coupon higher than the coupon the investor would receive on fixed income securities with comparable maturities. In addition to possibly providing a higher yield, a Reverse Convertible Note provides a protection level that is intended to protect an investor’s principal from a predetermined percentage decrease in the value of the underlying asset.
The other notable feature of a Reverse Convertible Note is that the issuer, upon maturity, has the right to deliver the reference asset to the investor. This occurs if the reference asset of the Reverse Convertible Note closes at a price below its protection level on any day throughout the life of the Note and at maturity the reference asset closes below its value on the initial valuation date. The delivered shares may have a lower market value at maturity than the full principal amount of the Note. Therefore, in exchange for a higher coupon, the investor must be prepared to accept the risk of losing some or all of the principal amount of the Note payable at maturity.
Unlike an investment in the reference asset, the appreciation potential in Reverse Convertible is limited to the coupon amount. The investor will not participate in the gains on the reference asset nor any dividends that may have been paid by the underlying security during the term of the Note.
- Purchase of a Reverse Convertible Note carries with it the risk of loss of some or all of the initial investment (the principal).
- Purchasing a Reverse Convertible Note, the investor also indirectly sells the issuer a put option which is the right for the issuer to deliver the underlying stock to the investor at maturity, the stock having lost some or all of its value since the original strike price was established.
- The purchaser of a Reverse Convertible Note should be financially capable of withstanding a loss, should understand how the option works and should be comfortable with the potential to receive stock worth less than the original investment instead of cash at maturity.
- As Reverse Convertibles are Notes issued by banks, the purchaser of the Note assumes the risk of the creditworthiness of the issuer and its ability to make principal and interest payments.
- There are some Reverse Convertible Notes that are issued with a call feature. This allows the issuer (not the investor) to redeem the Note before the maturity date. If the security is called, the investor may be faced with investing in a lower interest rate environment.
- For full information regarding the tax consequences of Reverse Convertible Notes, investors should review the prospectus or offering circular and consult with their tax advisor. Special tax treatment applies to Reverse Convertible Notes because they are comprised of two financial instruments: a debt instrument and an option. The debt portion is reported annually as income based on the coupon rate of comparably investment grade-rated (e.g. AA or Aa3) note of the same maturity of the issuer. This, because the Reverse Convertible pays a higher coupon rate that is lower than the actual rate. The option component is taxed at maturity as a short-term capital gain if cash (rather than shares of the underlying stock) is received at maturity. If shares are delivered at maturity (meaning that the principal has been reduced), the option component will reduce the tax basis of the underlying shares; no taxable event occurs until the shares are sold.