Structured Notes: The Devil Is In The Details

It sounds like an investor’s dream investment: You get 150% of the upside of the stock market but only 90% of the downside. As reported Jan. 16 by Bloomberg, that’s often what appears to be the promise behind structured notes issued by such companies as JPMorgan Chase & Co., Bank of America Corp. and Goldman Sachs Group.

Known as hybrid securities, these investments have maturities like bonds but are linked to asset classes such as stocks, currencies and commodities. And they are growing in popularity – especially in the case of structured notes linked to the stock market. These investments have grown 16.5% in the past year and 116% since March 2009, according to the Bloomberg article. All told, Bloomberg data show more than $10 billion of structured notes tied to the S&P 500 were issued in 2012, the highest amount in three years.

But the reality of structured notes can sometimes be brutal for investors. Unlike traditional index funds that contain a diversified basket of stocks, structured notes are subject to the creditworthiness of the issuer. Case in point: So-called principal-protected structured notes issued by Lehman Brothers.

When Lehman Brothers filed for bankruptcy protection in 2008, structured notes issued by the company lost most of their value. Investors who had purchased the Lehman Brothers’ notes from various brokerages were shocked because they had been told that their investment was designed to be 100% “principal protected.” As it turns out, that was far from the reality.

In 2011, the Financial Industry Regulatory Authority (FINRA) fined UBS Financial Services $2.5 million over the Lehman principal-protected notes, ordering the firm to pay $8.25 million in restitution for omissions and statements made to investors about the products.

According to FINRA, UBS’s statements regarding the notes effectively misled some investors about the “principal protection” feature of 100% Principal-Protection Notes issued by Lehman Brothers Holdings prior to its bankruptcy filing.

As the Bloomberg article points out, there’s a reason why some brokers may be less than upfront about the potential downside of structured notes to investors. It has to do with the hefty commissions that brokers receive – commissions that can be between 1.5% for a standard S&P 500 note to 10% or more for certain exotic structured notes that track custom benchmarks. Information about these commissions, however, is often buried in the fine print of the note’s lengthy and often confusing prospectus.