Article Spotlight

 

In this series we analyze current financial articles and explain how the conclusions of the article relate to our investment strategy.

Structured notes on a bargain – Is it too good to be true?

It is critical to read the fine print – especially with regard to investment products. In this Article Spotlight, we take a look at structured notes. A structured note is essentially a hybrid security: a bond with a maturity date, but able to yield returns that are linked to other asset classes such as stocks or indices.

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This article considers JPMorgan’s 18-month Buffered Return Enhanced Notes (BRENs) in their analysis. This particular note was issued on October 26, 2012 and matures on April 30, 2014. At maturity, investors will receive 150% of the S&P 500’s gain. The note also appears to provide some downside protection; if the S&P 500 drops less than 10% below the price on the issue date, investors lose nothing. If the index drops 20%, investors will only lose 10%.

Seems pretty good, right?

Not exactly.

If you read the fine print of the prospectus, it says, “The notes are designed for investors who seek a return of 1.5 times the appreciation of the S&P 500 Index up to a maximum return of 14.00% at maturity. Investors should be willing to forgo interest and dividend payments and, if the Ending Index Level is less than the Initial Index Level by more than 10%, be willing to lose up to 90% of their principal.”

There are two main issues with this note:

  1. Investors are capped at 14% upside, and
  2. Investors don’t receive dividend payments

Market returns are volatile. In some years returns will be up significantly, and those are the years that these investors will lose significantly. If the market were to rise 40%, you would lose 26 percentage points with this note.  If the market drops 40%, you would still lose 30%.  A lack of dividend payments is another significant problem with this note. Although the current yield on the S&P 500 is only around 2.10%, dividends historically have accounted for about 40% of an investor’s return.  One last issue of significance is the fact that investors are taking on credit risk.  If the issuer fails, it is likely an investor will receive little to nothing of their principal back.

All of these downsides are on top of the fact that the broker is receiving a commission for selling this note. For a simple S&P 500 note, the commission is most likely around 1.5%.

Always remember to read the prospectus of any investment. It will disclose how an investment actually works, which means you will have the knowledge necessary to ultimately decide whether it makes sense in the context of your individual investment circumstances.

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About Shan Zubair

As a financial advisor, Shan works closely with his clients to help define and commit to their retirement and investment objectives. Shan is a Certified Financial Planner™ and Chartered Mutual Fund Counselor (CMFC®).

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