January 16th, 2015
from the Securities and Exchange Commission
The SEC's Office of Investor Education and Advocacy is issuing this Investor Bulletin to inform investors of features - ; and some potential risks - ; of structured notes. While structured notes may enable individual retail investors to participate in investment strategies that are not typically offered to them, these products can be very complex and have significant investment risks. Before investing in structured notes, you should understand how the notes work and carefully consider their risks.
What are Structured Notes?
Structured notes are securities issued by financial institutions whose returns are based on, among other things, equity indexes, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies. Thus, your return is "linked" to the performance of a reference asset or index. Structured notes have a fixed maturity and include two components - ; a bond component and an embedded derivative. Financial institutions typically design and issue structured notes, and broker-dealers sell them to individual investors. Some common types of structured notes sold to individual investors include: principal protected notes, reverse convertible notes, enhanced participation or leveraged notes, and hybrid notes that combine multiple characteristics.
Risks and Other Considerations with Structured Notes
Complexity. You and your broker should take time to fully understand the manner in which your return on a structured note is calculated. You should understand the reference asset(s) or index(es) and determine how the note's payoff structure incorporates such reference asset(s) or index(es) in calculating the note's performance. This payoff calculation may include leverage multiplied on the performance of the reference asset or index, protection from losses should the reference asset or index produce negative returns, and fees.
Market risk. Some structured notes provide for the repayment of principal at maturity, which is often referred to as "principal protection." This principal protection is subject to the credit risk of the issuing financial institution. Many structured notes do not offer this feature. For structured notes that do not offer principal protection, the performance of the linked asset or index may cause you to lose some, or all, of your principal. Depending on the nature of the linked asset or index, the market risk of the structured note may include changes in equity or commodity prices, changes in interest rates or foreign exchange rates, or market volatility.
Issuance price and note value. The price you will pay for a structured note at issuance will likely be higher than the fair value of the structured note on the date of issuance. Issuers now disclose an estimated value of the structured note on the cover page of the offering prospectus, allowing investors to gauge the difference between the issuer's estimated value of the note and the issuance price. The estimated value of the notes is likely lower than the issuance price of the note to investors because issuers include the costs for selling, structuring or hedging the exposure on the note in the initial price of their notes. After issuance, structured notes may not be re-sold on a daily basis and thus may be difficult to value given their complexity.
Liquidity. Your ability to trade or sell structured notes in a secondary market is often very limited as structured notes (other than exchange-traded notes known as ETNs) are not listed for trading on security exchanges. As a result, the only potential buyer for your structured note may be the issuing financial institution's broker-dealer affiliate or the broker-dealer distributor of the structured note. In addition, issuers often specifically disclaim their intention to repurchase or make markets in the notes they issue. You should, therefore, be prepared to hold a structured note to its maturity date, or risk selling the note at a discount to its value at the time of sale.
Payoff structure. Structured notes may have complicated payoff structures that can make it difficult for you to accurately assess their value, risk and potential for growth through the term of the structured note. Determining the performance of each note can be complex and this calculation can vary significantly from note to note depending on the structure. Notes can be structured in a wide variety of ways. Payoff structures can be leveraged, inverse, or inverse-leveraged, which may result in larger returns or losses for you. You should carefully read the prospectus for a structured note to fully understand how the payoff on a note will be calculated and discuss these issues with your broker. For example, the payoff on structured notes can depend on:
- Participation rates. Some structured notes provide a minimum payoff of the principal invested plus an additional payoff to you based on multiplying any increase in the reference asset or index by a fixed percentage. This percentage is often called the participation rate. A participation rate determines how much of the increase in the reference asset or index will be paid to investors of the structured note. For example, if the participation rate is 50 percent, and the reference asset or index increased 20 percent, then the return paid to you would be 10 percent (which is 50 percent of 20 percent).
- Capped maximum returns. Some structured notes may provide payments linked to a reference asset or index with a leveraged or enhanced participation rate, but only up to a capped, maximum amount. Once the maximum payoff level is reached, you do not participate in any additional increases in the reference asset or index. For example, a note may provide the investor 100% of all funds invested at the end of two years, plus an enhancement of any rise in the performance of the S&P 500 up to 20%. If the performance of the S&P 500 increases 25% in those two years, you only receive a return of 20%.
- Knock-in feature. If the reference asset or index falls below a pre-specified level during the term of the note, you may lose some or all of your principal investment at maturity and also could lose coupon payments scheduled throughout the term of the note. This pre-specified level may be called a barrier, trigger, or knock-in. When this level is breached, the payout return changes on the note. For example, if the reference asset or index falls below the knock-in level and its value is lower than on the date of issuance, instead of receiving a return of your principal, you may instead receive an amount that reflects the decline in value of the reference asset or index. For certain types of structured notes, you may actually receive the reference asset that has declined in value during the term of the note.
Credit risk. Structured notes are unsecured debt obligations of the issuer, meaning that the issuer is obligated to make payments on the notes as promised. These promises, including any principal protection, are only as good as the financial health of the structured note issuer. If the structured note issuer defaults on these obligations, investors may lose some, or all, of the principal amount they invested in the structured notes as well as any other payments that may be due on the structured notes.
Call risk. Some structured notes have "call provisions" that allow the issuer, at its sole discretion, to redeem the note before it matures at a price that may be above, below or equal to the face value of the structured note. If the issuer "calls" the structured note, investors may not be able to reinvest their money at the same rate of return provided by the structured note that the issuer redeemed.
Tax considerations. The tax treatment of structured notes is complicated and in some cases uncertain. Before purchasing any structured note, you may wish to consult with a tax advisor. You also should read the applicable tax risk disclosures in the prospectuses and other offering documents of any structured note you are considering purchasing.
Questions to Ask Before Investing in Structured Notes
Before investing in any structured note, do your research to answer the following questions, or ask your investment professional:
- What are the fees and other costs associated with the investment?
- How much above an issuer's estimated value of a structured note will I be paying for the structured note? Do I know the issuer's estimated value and its relevance to my investment decision?
- How do I know whether this product is appropriate for me given my overall investment objectives? Structured notes may not be a suitable investment for you. You should review your investment objectives and tolerance for risk with your broker or financial adviser before you consider investing in a structured note. They can help you determine whether the risks associated with a particular structured note are within your tolerance for risk, or whether your investment needs are better served by investing in another product. Your broker must only recommend securities transactions and investment strategies for your brokerage account that are suitable based on your investment profile.
- What other investment choices are available to me? Are other products available that provide investment exposure to similar assets, indices or strategies? If so, how do the costs of these other products compare to those associated with the structured note? Carefully consider what might be a suitable investment for you, and whether there are better alternatives to the structured note you are considering. For example, can I purchase some or all of the components of the structured note separately for a better price?
- How long will my money be tied up? Many structured notes are meant to be held to maturity. If you need your money back prior to maturity, you could lose a significant portion of your investment.
- Can I sell or otherwise liquidate my investment before the maturity date? A liquid market for structured notes does not exist. If you want to sell your structured note before it matures, you might have to do so at a price less than the amount you paid for it, or you may not be able to sell it at all.
- Is there a call feature? If so, be sure you understand what can trigger the call and the earliest date that the structured note may be called. You will also want to ask your investment professional about a strategy in the event your structured note is called.
- Are potential returns limited? Some structured notes have caps on the returns you can earn based on the performance of the reference asset or index.
- What are the tax implications? You might wish to consult with a tax advisor to understand the consequences of any particular structured note, including imputed interest and any foreign tax consequences.
- How does the payoff structure work? Is it possible to lose money, or not have any gain at all, even if the reference asset or index goes up? Purchasing a structured note does not guarantee positive returns. For example, the reference asset or index might not increase in value—or even if it does, there may be conditions that limit your returns.
- What is the credit risk of the issuer of the structured note? Remember that any payoff on a structured note is subject to the creditworthiness of the issuer. Be sure to understand the financial condition of the issuer and read its disclosures as carefully as you would for any other investment.
- Do I understand the investment? Many structured notes are complex. If you do not understand how the structured note works, ask your investment professional for help. If you still do not understand the structured note, you should think twice about investing in it.
For additional educational information for investors, see the SEC's Investor.gov website or the Office of Investor Education and Advocacy's homepage. For additional information related to structured notes, also see:
- SEC/FINRA Bulletin: Structured Notes with Principal Protection: Note the Terms of Your Investment
- FINRA Bulletin: Reverse Convertibles - ; Complex Investment Vehicles
The Office of Investor Education and Advocacy has provided this information as a service to investors. It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the meaning or application of a particular law or rule, please consult with an attorney who specializes in securities law.