In mid-December, Jason Zweig of The Wall Street Journal discussed the importance of investor checklists in his Intelligent Investor column.  The article, A Checklist for Investors, observes that investment checklists are surprisingly underused, despite the obvious benefits.  He writes “By building a checklist—a standardized set of questions you must answer before you commit to any investment decision—you can reduce the risk of making costly errors.”  I agree with that message wholeheartedly. Given the New Year, it is an opportune time to create a checklist template specifically crafted for structured note investments.

As I hope you know from reading this blog, I am a strong believer in structured products.  They are customizable instruments that empower investors to achieve all sorts of investment objectives that are difficult, if not impossible, to replicate through other means.  I am also a big proponent of investor education, especially as relates to structured notes, because they tend to be complex, are often misunderstood, and are not always the best means of achieving an investors goals.  In that spirit, I have developed the following Structured Notes Investor Checklist.  It includes important questions that every investor should address carefully before purchasing a structured note.  As always, I look forward to your feedback and comments.

Structured Notes Investor Checklist:

Five Important Things to Know BEFORE You Invest

 
1.  What exactly am I purchasing?  Generally, structured notes provide exposure to an underlying index, security or group of securities. In many instances it is exposure to a well-known security, such as Apple, or index, such as the S&P 500. The performance of your investment will be typically driven entirely by the performance of the underlier, so a clear understanding of the characteristics of the underlier is absolutely essential to making an informed decision about structured notes.

Giving full treatment to all potential underliers is beyond the scope of this article, but here’s a few thoughts to share:

Single security underliers are the most straightforward to work with.  Even so, the investor should make sure he/she understands the type of security this is (e.g., defensive stock, growth stock) and its historical and expected performance.  With single stocks, it is also of particular importance to understand if volatility is historically high. High volatility may result in return characteristics seeming better than expected but also usually means there is a risky event on the horizon – it is important for you to understand these implications thoroughly in making an investment decision.

For indexes, beyond understanding all the components of an index, you should review how often and when the index rebalances and have a general understanding of how the index was designed to perform in different market conditions.  In recent years there has been tremendous growth in the use of proprietary indexes inside structured notes, which presents unique issues. Specifically, many of these indexes are complex, lack a track record, and present inherent conflicts of interest.  In a recent article on this subject, Bloomberg Brief Structured Notes examined a bank note with a notional of $230 million based on the JP Morgan Enhanced Beta Select Backwardation Alternative Benchmark Total Return Index.  The title of the index, which was created two months prior to the note creation, is a mouthful to say the least.  I found the index to be complex and needed to invest significant time to simply have a relative understanding of it – and if I was contemplating purchasing a note based on this index I would need to spend considerable more time analyzing the index to get comfortable making an investment.

When multiple securities are used, whether in a basket or in comparison to one another (e.g., a Worst-of, where the investor might receive a yield in return for downside risk related to the worst performer of a portfolio of underliers), investors need to have a general understanding of the underlying securities and how they move in relation to one another (correlation).  For example, A basket consisting of the S&P 500 and 30 year bonds, which are negatively correlated (i.e., generally move in the opposite direction) will have a very different return profile due the relationship than Goldman Sachs and Morgan Stanley, two large US based investment banks which are positively correlated (i.e., generally move in the same direction).

To recap, the underlying index and/or security of a structured note is an integral element of a structured note investment.  If the underlier is too complex to get comfortable with, move on to the next investment opportunity.
 
2.  How does this note perform at maturity (and understand all of the fine print!)

A distinct characteristic of a structured note is the defined outcome at maturity.  Make sure you understand what that outcome is supposed to be based on the potential outcomes of the underlying security or index.  For example, if a note provides 10% fixed downside protection through a buffer on the S&P 500, then you know that if the S&P is down 5% you should receive 100% of principal at maturity, while if the S&P 500 is down 15% you should receive 95% of principal at maturity.

Give special attention to potential bells and whistles of the transaction.  For instance, understand the difference between fixed terms (e.g., buffered protection provides a fixed amount of protection regardless of how the index performs) and contingent terms (e.g., barrier protection provides protection as long as the index doesn’t go below a certain level).  To illustrate the difference in these terms, a 10% buffer provides 10% of protection if the S&P is down 15%, but a 10% barrier provides no protection in that same scenario.

There are other examples of fine print which can significantly impact a deal’s attractiveness.  I have focused on examples of these in prior blogs.  For example, my first blog noted an 8% headline yield which in reality simply got the investor back to a flat return position while a more recent blog touched on how a callable feature significantly reduces the expected yield to investors.  Make sure to review all elements of a term sheet no matter how unessential they may seem at first blush.

If a term sheet is not understandable then move on to something you do understand.  That philosophy worked fine for Warren Buffet all these years... 
 
3.  Who is issuing the note and what is their credit rating?  Structured notes are senior unsecured debentures from the issuer, which essentially means they have the same credit risk as corporate bonds.  Although highly unlikely, it is possible that an issuer will default (e.g., Lehman, and potentially several others had the Fed not intervened).  In addition to making sure you are not overly concentrated in a particular credit, you should also check, if possible, that the yield being provided within the note is in line with the issuer’s current CDS/Yield rate.  If it isn’t, you may be able to achieve a far superior investment by replicating the structured note on your own.  (Note: this becomes trickier when dealing with embedded call features by the issuer where the term of the investment is actually variable.  For example, the recent structured CD I had analyzed could be called as early as 5 years after issuance but may last up until its stated maturity of fifteen years.  In these instances, a good understanding of the probabilities of an early call is necessitated to truly understand the yield you should receive.)
 
4.  When do I plan on exiting this position?  A structured note should be purchased with the intent to hold until maturity – these are not liquid securities, so exiting early will likely be expensive.  However, it is important to understand what the cost might be if you need to exit early for any reason, especially on longer dated notes.  Make sure to discuss early exit options (both from the issuer as well as in the secondary market) with your sales rep.  Try to get an understanding of how wide a market there is likely to be if an exit is necessary.  Structured CDs in particular might be relatively hard to get out of and can be very sensitive to interest rate moves based on their duration (e.g., link to CD Blog).  While you may view your structured note investment as a buy and hold play, it is important to understand what kind of discount to value you may take if an exit is necessary.
 
5.  Is a structured note the best format for achieving my investment objective?  For most individual investors and even many institutions, having a structured investment packaged together by a bank is the only reasonable way to achieve an institutional level of customization.  But for some investors, it may be more efficient to recreate the investment using other means that don’t present the complexity, illiquidity, and concentrated credit risk of a structured note.
 
Structured notes often provide compelling, tailored investment opportunities in a single package.  However, they are sometimes complex, illiquid, and expensive.  The above checklist should be utilized in making sure a given structured note is right for you.