Expat Investment Advice: Structured Products — Buyer Beware
By Chad Creveling, CFA and Peggy Creveling, CFA
The potential for higher-than-market yields coupled with full or partial principal protection offers a compelling combination of benefits for investors, especially in today's low interest rate environment. Catering to investors' need for security and desire for higher returns, private banks and other financial institutions in the offshore markets have jumped on the structured product bandwagon. Structured products come in all shape and sizes, but typically embed a derivative structure with the payout tied to the performance of a reference index or set of indices and may include full or partial principal protection. While the benefits often seem enticing, the inner workings, risks, costs, and payoff structures are little understood, particularly to the retail client to whom these products are heavily marketed.
Enhanced Yield, Partial Principal Protection
The following Quarterly Income Note offered by a leading private bank is an example of one type of widely marketed structured product. The key features include:
- The potential for quarterly coupons above market rates in a choice of major currencies for a five-year investment term. The offered USD coupon on the product was 1.7% per quarter or an annual yield of 6.8%.
- The payment of the coupon each quarter is determined by the performance of three major equity indices: the S&P 500, the EURO STOXX 50, and the FTSE 100 Index.
- Each quarter the note pays the preset coupon as long as all three indices are at or above a preset barrier.
- The barrier in this case is set at 80% of each index's starting level at the beginning of the investment period. Each quarter on a set observation date, if none of the three indices has fallen more than 20% from their starting levels, the coupon is paid. If any of the indices has fallen by more than 20%, or breached the barrier, the coupon is not paid for that quarter.
- At the end of the five-year term, the principal is paid in full as long as all three indices are at or above the barrier on the maturity date. If any of the indices has breached the barrier at the maturity date, then the principal repayment is dependent on the worst performing index. For example, if one or more of the indices has breached the barrier at maturity and the worst performing index has fallen by 35%, then the investor would get back only 65% of their original principal.
This is a pretty straightforward structured product, and the key details and risks are clearly outlined in the product note provided by the bank. The problem is that most retail investors don't really understand what they are buying to include the risks, payoff structures, and the probabilities of obtaining a particular payoff. These products are also usually sold by “advisors” who work as selling agents by the bank or other financial intermediaries and don't necessarily understand the product themselves or don't clearly provide all the information required for the investor to make an informed decision.
The Illusion of Security
The typical investor will simply focus on the enhanced yield without fully understanding the chance of actually receiving that return given the dependence upon the performance of a basket of highly volatile equity indices. The investor may think that they have traded away the volatility of equity for more stable bond-like coupon payments and partial principal protection, but instead they've capped their upside while retaining unlimited downside equity risk. The investor could have invested equally in the underlying equity indices. They would be exposed to short-term equity volatility, but the upside would not be capped and they would retain essentially the same equity risk as holding the structured product.
Actually, the downside risk would be less, as the initial investment would be spread across the three indices, while the downside for the structured product is tied to the worst performing index only. Consider if at maturity the three indices stood at 150%, 135%, and 65% of their initial levels. On an original investment of $1,000, the investor would receive $1,167 at maturity if they invested equally in the three indices, but only $650 if invested in the structured product. Any loss on the structured product is partially offset by any quarterly coupons received, but consider that the investor also gives up any dividends paid on the underlying indices.
In sum, the investor forfeits dividends and full participation in the appreciation of the underlying indices in exchange for the chance (not guarantee) to earn a fixed coupon each quarter and partial principal protection while retaining virtually unlimited downside equity risk.
Impact of Missed Payments
The table below provides some indication of the payoff structure for this type of product.
Meets all coupon payments/full redemption/no fees
Misses 4 of 20 coupon payments
Misses 7 of 20 coupon payments
If all coupons are paid and the full principal is returned, the product generates an annualized return or internal rate of return (IRR) of 6.80%. This is the best you can do before considering fees and any taxes.
There is no assurance that you will receive the coupon in any one quarter or receive your full principal at maturity. Payments are linked to highly volatile indices that individually carry a significant risk of breaching the 80% barrier in any one quarter. Tying the payoff to three volatile indices rather than one actually increases the odds that the barrier will be breached and the coupon not paid.
There are 20 quarters or scheduled coupon payments over the five-year term. Missing just four of those payments drops the return on the product or IRR to 5.29%. Missing seven of the 20 coupons drops the IRR to 4.25%. Whether missed coupons occur in the beginning, middle, or end of the investment period will affect the IRR slightly. For this example, we've assumed the missed coupon payments occur in the beginning of the investment period.
Determining the probability of receiving a coupon or full principal at maturity is virtually impossible without sophisticated software. Retail investors, who are unable to calculate or intuitively understand the probabilities, tend to underestimate or entirely discount the risk of missed coupon or reduced principal payments.
Impact of Fees
There are a number of implicit and explicit fees attached to the structured product. First, there is a 4% distribution fee. Accounting for the 4% fee drops the 6.80% IRR to 5.87% before accounting for any risk to coupon or principal repayments. In this case, the product also resides inside an insurance wrapper that charges an ongoing fee of 0.3125% per quarter or 1.25% per year over the structured product's investment period. Add in the impact of the distribution fee, and the insurance wrapper fee drops the IRR to 4.65%.
This means that 4.65% is the best you can do before accounting for risk to coupon or principal payments.
Adding four missed coupon payments to the impact of fees drops the IRR to 3.23%. Assuming the barrier is breached at maturity resulting in only 65% of the principal returned coupled with four missed payments drops the annualized return (IRR) to a negative 4.13%.
|Impact of Fees
Add in 4% distribution fees/meets all payments/full redemption
Add in 4% distribution fee and 0.3125% quarterly fee
Add in all fees and miss four payments
Add in all fees/miss four payments/65% redemption value
Other Key Risks/Considerations
In addition to the uncertainty of the payoff structure and the impact of fees, there are a number of other issues to consider:
Counterparty risk: A structured product is an unsecured obligation of the issuing bank, and the ability to pay depends on the creditworthiness of the issuer. If you think this risk is insignificant, consider what happened to all the holders of structured products issued by Lehman Brothers.
Liquidity: These products are illiquid. Many do not trade on exchanges and rely on the issuing bank to make a market. Even if the bank is willing to make a market for these products prior to maturity, there will typically be a heavy cost resulting in returning significantly less than your original principal. Even if the product is listed, liquidity is typically limited, resulting in poor pricing. Additionally, the value of the product prior to maturity is the discounted expected cash flow, which given the derivative structure is dependent on the level of the linked indices, their volatility, interest rates, time to expiration, and other factors. As a result, prior to maturity these products can typically be redeemed only at a significant loss to principal.
Implicit fees: In this example, we've accounted for only some of the major explicit fees. There can also be administration charges, bid-offer spreads, dealing charges, advisory charges, and other fees embedded in the insurance wrappers that hold these products. There are also the implicit costs that come from the packaging or structuring of the product which include the issuer's cost of hedging and often a substantial profit margin. These costs are very difficult for a retail investor to understand and discern, but will typically result in less principal protection or a capped upside than what the investor could have achieved had they assembled the structured product on their own.
Taxes: The tax treatment of structured products and the insurance wrappers that typically hold these investments are complex. As an expat, you may or may not be taxed by your country of residence on these products. As an American expat, you will be taxed on both the structured product and the insurance wrapper regardless of your country of residence. Needless to say, prior to purchasing, consult your tax advisor, and if you don't understand how you will be taxed on these products, don't purchase them.
There Is No Free Lunch
When it comes to investing, there is no free lunch. This is particularly true for structured products. If you don't fully understand the payoffs associated with the range of possible outcomes, the probabilities of achieving particular returns, the risks, and the impact of fees and taxes, then you probably shouldn't be investing in the product.
As a final note, structured products come in all shapes and sizes and need to be analyzed individually based on the unique structure of the product under consideration.
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