A structured product is type of hybrid security, a security that combines two or more different financial instruments, with both a debt and an equity component. Structuredproducts are a debt obligation of the issuer with an embedded derivative component, which is a security whose price depends on or is derived from one or more underlying assets. Generally, structured products do not represent ownership of the underlying assets; rather, they are promises to pay made by the structured product’s issuers. Common underlying assets include market indexes, stocks, commodities, currencies, interest rates, or baskets of various asset types (all will be referred to as “underlying asset(s)” for purposes of simplicity).
Among other risks, structured products are subject to the credit risk of the issuer, as well as the market risk of the underlying assets. Structured products are often difficult to price and sell and, thus, may not be appropriate for investors seeking liquidity. Structured products also carry various expenses, including sales commissions, management fees, structuring fees, or early redemption fees that should be considered prior to making an investment decision.
Principal Protected Notes
A “principal protected” note is a structured product that offers either full or partial return of the investor’s initial investment (principal) at maturity. Principal protected notes typically reflect the combination of a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product. The note’s derivative component determines the security’s risk or return profile. That is, the amount of interest on the bond is determined by fluctuations in the underlying asset. The product will have a set maturity date, which typically ranges up to ten years from issuance.
A principal protected note is designed to protect some or all of the principal even if the value of the underlying asset declines. The amount that is protected can range from 10% to 100%. There are also “contingent protection” notes, which provide protection only if a specified contingency is met. Therefore, the investor may not receive any protection, despite sales materials implying otherwise.
Some principal protected notes give the investor periodic interest payments, while others pay a lump sum at the maturity date. The investor’s return is linked to the value of the underlying derivative, but will also depend on other factors that vary depending on the terms of the note.
A reverse convertible is a structured product that typically consists of a high-yield, short-term note of the issuer that is linked to the performance of an unrelated reference asset, usually common stock. Essentially, the buyer of a reverse convertible sells the issuer a put option on an unrelated equity and buys a high-yield bond of the issuer. The initial investment for most reverse convertibles is $1,000 per unit and most have maturity dates ranging from three months to one year.
The coupon rate on the note component of a reverse convertible is usually higher than the yield on a typical debt instrument, sometimes reaching annual coupon rates as high as 30%. An investor buying reverse convertibles is looking for a high coupon payment while making a bet that the underlying stock will either go up in price or remain stable. These are highly complex and risky investments. Both FINRA and the SEC have issued alerts about the unsuitability of reverse convertibles for most investors, stressing how important it is for both investors and registered representatives to understand the complexity of the product. See FINRA Regulatory Notice 10-09.