Structured products

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Structured products are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency.[note 1] As the foregoing definition suggests, there are myriad types of structured products. Some structured products offer full protection of the principal invested, whereas others offer limited or no protection of the principal.[1]

Most structured products pay an interest or coupon rate substantially above the prevailing market rate. Structured products also frequently cap or limit the upside participation in the reference asset, particularly if some principal protection is offered or if the security pays an above-market rate of interest.[1] (Refer to the graph below).

Structured products, which are typically issued by investment banks or their affiliates, have a fixed maturity. Some, but not all, structured products may be listed on a national securities exchange. Moreover, even those structured products listed on a national securities exchange may be very thinly traded.[1]

Structured products typically have two components—a note and a derivative[note 2] (often an option). The note pays interest to the investor at a specified rate and interval. The derivative component establishes the payment at maturity. In some products, the derivative is, in effect, a put option sold by the investor that gives the issuer the right, but not the obligation, to sell the investor the reference security or securities at a predetermined price. In other products, the derivative is, in effect, a call option sold by the investor that gives the issuer the right, but not the obligation, to buy from the investor the reference security or securities at a predetermined price. Despite the derivative component of a structured product, they are often marketed to investors as debt securities.[1]

Rules and regulatory requirements

Structured products are not specifically defined in the securities laws... Many involve innovative financing techniques creating customized financing and investment products to suit specific financial needs of customers. Such transactions may be structured for any number of reasons — for example, for principal protection, tax minimization, accounting cosmetics, monetization, or other specific purposes.[2]

Sales of certain structured products have increasingly been targeted at retail customers. Therefore, the U.S. Securities and Exchange Commission (SEC) and the self-regulatory organizations (SROs) are focusing attention on sales of structured products.[note 3][2]

A broker-dealer that does business with a public customer makes an implied representation that it will deal fairly with the customer in accordance with industry standards. This gives rise to obligations under the U.S federal securities laws, including the obligation to recommend only specific securities or investment strategies suitable for the customer. Both the NASD and the New York Stock Exchange (NYSE), two key U.S. SROs, have suitability rules.[2]

(The referenced SEC speech[2] contains an overview of detailed rules governing broker-dealer accountability, as well as SEC guidance on the potential liability of financial institutions for securities law violations arising from deceptive structured finance products and transactions.)

Taxes

Structured products may be considered contingent payment debt instruments for federal income tax purposes. This means you'll usually have to pay income taxes each year on imputed annual income even though you may not receive a cash payment until maturity. In addition, any gain realized upon the sale of these products may be treated as ordinary income.[3]

Structured notes

A structured note is an IOU[note 4] from an investment bank that uses derivatives to create the desired exposure to one or more investments.[4] Most of these notes make no payments prior to maturity and are generally not callable prior to maturity. At maturity, the securities offer maturity payments which are based on the results of a stock market index, such as the S&P 500, over the term of the note.[5]

The only advantage of a structured note is to provide customized payouts and exposures. Disadvantages include:[4]

  • Credit Risk: You bear the risk that the investment bank forfeits on the debt. A structured note adds a layer of credit risk on top of market risk.
  • Liquidity Risk: Structured notes rarely trade after issuance and are very illiquid.[note 5]
  • Daily Pricing: Pricing accuracy is questionable because most structured notes never trade after issuance. Prices are usually calculated by a matrix, which is very different than net asset value.

The most common type of structured note is the Buffered Return-Enhanced Note (BREN). Buffered means it offers some but not complete downside protection. Return-Enhanced means it leverages market returns on the upside. The BREN is pitched as being ideal for investors forecasting a weak positive market performance but also worried about the market falling.[4]

Buffered Enhanced-Return Note Concepts
Buffered Return Enhanced Note Example.png

Examples

Investopedia provides 2 notional examples:

A real-world example is discussed in this forum thread: Wiki - Structured Products

Notes

  1. There is no standardized definition of a structured product in the federal securities laws. SEC Rule 434 (Prospectus Delivery Requirements in Firm Commitment Underwritten Offerings of Securities for Cash) defines structured securities differently than the Pacific Exchange. (Refer to Footnote 1 in the NASD Guidance)
  2. A security whose price is dependent upon or derived from one or more underlying assets. Derivative, from Investopedia
  3. As of July 16, 2010, the SEC is creating an office focused exclusively on disclosure reviews and policy-making for asset-backed securities and other structured finance products. SEC Adds Units to Oversee Financial Institutions, Asset-Backed Securities, New Financial Products and Trends
  4. "I Owe You", a legally binding agreement between a borrower and a lender. IOU, from Investopedia
  5. A security that cannot easily be sold or exchanged for cash without a substantial loss in value. illiquid, from Investopedia

See also

References

External links

Regulatory

Forum discussions

Other references