Quirkiest Vehicle On The Street

Structured notes can offer high yields and principal protection. But they come with some serious drawbacks

With the growth of exchange-traded funds, hedge funds, and separate accounts, investors have all sorts of newfangled ways to pump up their portfolios. Now, many advisers are pushing yet another product: structured notes.

Popular with individual investors in Europe and Asia, these option-based investments alter the risks and potential rewards of buying stocks, bonds, or other securities. Until recently, these notes have been used in the U.S. mainly by institutional investors. But hundreds of private banks, brokerage firms, and independent advisers are starting to sell them. The market: mainly "middle- to high-net-worth individuals," says Richard Mikaliunas, senior vice-president at the American Stock Exchange, which lists about 85% of the structured products that trade on exchanges. For $1,000 each, you can even buy a few structured notes on Fidelity Investments' Web site, Fidelity.com.

While structured notes can offer an assortment of attractions, from high yields to principal protection, this relatively undeveloped market has some serious downsides. Among them: sometimes opaque fees, poor liquidity, and a high degree of complexity. "I like some of them--provided the fees are low," says Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm specializing in derivatives. "But even many advisers are not able to deconstruct a note to determine if it is a good value."

Structured notes are not issued by corporations or government entities looking to raise money. Instead, financial institutions create them to fill an investment need and make a buck for themselves. The minimum investment is usually $1,000. They can be based on stocks, bonds, commodities, or currencies. Right now, the most popular structured notes give investors exposure to a single stock or broad market index, such as the Standard & Poor's 500-stock index or the Nikkei.

What distinguishes structured notes from straightforward stock or index funds is that they expire within a set period--typically from 1 to 10 years. Many also incorporate options to limit risks or magnify gains. A recent Morgan Stanley (MS ) offering exemplifies a common variety of structured note. If the S&P 500 rises between Oct. 27, 2006, and Nov. 28, 2007, the note will deliver twice the gains, up to 12%. Another type of note, often pegged to the S&P 500 or another stock market index, offers protection against losses. When the note expires, the investor gets the principal back, whether the index rises or falls. But if it rises, the investor generally gets some gains. Other notes magnify gains, often at the cost of some principal protection.


Yet another popular breed of structured note, called a reverse convertible, offers high yields. A recent reverse convertible from Barclays, (BCS ) for example, is built on an underlying investment in General Motors (GM ) shares. The note will pay interest at an annual rate of 16% when it matures on Feb. 8 of next year. The note may also pay back the principal. But if GM declines by 20% or more over the life of the note and returns are negative by the note's maturity date, the investor will receive depressed GM shares instead of cash. "You'll get a nice coupon, but if the stock declines, that income may not be enough to offset your losses. That's the risk you bear," says Joe Burris, head of sales and marketing at structuredretailproducts.com, a Web site that maintains a database of structured products that have been registered with the Securities & Exchange Commission.

Advisers say they use structured notes in a variety of ways. When a market is plodding along, a leveraged note can amplify returns. Notes can also fine-tune an investor's asset allocation strategy, raising returns without increasing risk. Rhian Horgan, global head of equity derivatives at JPMorgan (JPM ) Private Bank, says that by buying a note with some downside protection on, say, the S&P 500, an investor may be able to increase exposure to riskier assets with higher expected returns, such as private equity, without raising overall risk.

Protection may come at a steep price. When you buy a structured note, you'll pay your bank or brokerage firm as much as 1.5% to 2% of your total investment for a one-year note. That's built into the price. Fees may be even higher for notes with longer maturities, says Tavakoli. The cost of a note also includes some amount--often 0.5% to 1%--that goes to the investment bank that issued the note, she says. While the prospectus will spell out the distributor's fees, it may not disclose the investment bank's. And if you work with a broker, you may pay yet another commission.

The fees are levied up front. When amortized over the life of a note, "in some instances, they are less than those on comparable mutual funds," says Philippe El-Asmar, managing director at Barclays Capital, a big issuer of structured notes. If you buy a principal-protected note for $1,000, the fees won't cause you to get back less than the $1,000 you put down, as long as you hold the note to maturity, Tavakoli says. But they may reduce the leverage you'll get via the options market. For example, a note with high fees might promise to pay only 1.5 times the gains of the S&P 500, vs. two times for a comparable but cheaper alternative, she adds.

Liquidity is another concern. If you want to sell a structured note before it matures, your broker or bank will most likely buy it back. But there are no guarantees. Moreover, as with other thinly traded securities, the spread between the purchase and sale prices that dealers quote can be wide, with the norm around 1%.

Conflicts of interest may also put investors at a disadvantage. Because the U.S. structured note market is young, private banks and brokerage firms still often favor notes produced by affiliated investment banks. The worry, of course, is that they may not always procure the best deals.


The features and terms of these notes can be complicated, too. For example, if you sell a principal-protected note before it matures, you're no longer entitled to principal protection. Instead, you'll receive the market value of your note, which may be greater or less than what you paid. Investors in these notes don't typically receive dividends.

The tax treatment varies. Notes that fully protect principal are generally treated like bonds and are subject to income-tax rates of up to 35%. In contrast, profits on notes with no downside protection are taxed at capital-gains rates of up to 15%, provided you hold them for at least a year. But the tax treatment of notes that offer some, but not full, principal protection isn't always clear.

Investors don't have to meet any net worth or income requirements to buy structured notes. But the National Association of Securities Dealers has urged member firms to sell structured notes only to sophisticated investors. All others should stick with simpler but more transparent investments.

By Anne Tergesen

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