Structured Notes Gone Wild
Introducing our first “Structured Notes Gone Wild” segment – the most interesting, unusual, or just wacky ideas we’ve come across. One of the compelling elements of structured investing is that design is only limited by the human imagination. Below, I highlight five of the most creative notes I have come across, two which were mentioned in a recent WSJ article by Jason Zweig.
2x – 3x Leverage Trigger Note
Characteristics: Investor receives 2x upside exposure to the common stock of Bank of America up to a cap of 18.10% unless the stock falls below 95% of its initial price during the first three months of the note, in which case the investor receives 3x leverage up to a 27.15% cap; full downside exposure.
This note requires a real probability analysis to evaluate. The note functions in most cases like a typical leveraged structured note – 200% participation up to an 18% cap and full downside participation. It outperforms in moderately positive markets, slightly underperforms in down markets due to loss of dividend, and has a risk of real underperformance in a runaway bull market.
However, it also contains a special “super leverage” feature (a teaser if you may) – if the market dips below 5% within the first three months of issuance, the leverage increases from 200% to 300% and the cap increases to 27.15% from 18.1%. Of course, the market has to get back to positive territory for any of this to matter. The nice thing about this feature is that it kicks in just when an investor would be regretting his or her purchase.
Here is a question: How much is the “super leverage” feature worth to you? If the bank removes the “super leverage” feature, how much higher would it need to raise the 18.1% cap on the 200% base case leverage to provide an equivalent value? Off the cuff answers only! No Bloomberg pricing allowed – please send me your answers and, assuming sufficient responses, I will provide the average along with the actual fair value in a future post.
Characteristics: Investor receives 20% return after 2.25 years if the Russell 2000 ETF is between -15% and + 25%; 0% if over 25%; and a leveraged (118%) loss if the return is lower than -15%.
If you are convinced the market won’t go on a bull run over the next 28 months, this would have been an interesting note to consider. It returns 21% as long as the Russell 2000 ETF returns between -15% and +25%, which is a fairly wide swath of territory. If the Russell drops below -15%, this note still outperforms nicely.
However, there is a catch – if the market is up more than 25%, the investor gets their principal back only, resulting in a material underperformance. Which means that while your friends are celebrating the bull run you will be the loneliest person on Wall Street.
So in summary, this note outperforms as long as the market returns 20% or lower, and the odds are in favor of that scenario. But expect to be disappointed if the market takes off.
Characteristics: Investor receives 16.5% after one year if the worst performer between S&P 500 and Russell 2000 is above -10%; 0% if between -10% and -20%; and 2X the total loss if index is below -20%. (This results in quite the cliff – if the worst performer is down 19.9% the investor gets back his principal but if it is down 20.1% the investor is stuck with a 40.2% loss!)
If you are convinced the market won’t move much higher or lower in the next year, and are willing to lose big if you are wrong, you might have been interested in this product.
This product generates a 16.5% return as long as both the S&P 500 and the Russell 2000 are above -10% after a year, and it generates a flat 0% return if they are between -10% and -20%. Thus, the note outperforms if these indexes are both between -20% and positive 16.5%.
However, here’s the catch – if either of the indexes returns below 20%, the return is 2X the downside performance – e.g., S&P down 21%, note returns -42%.
A more traditional digital product would offer 1X downside and pay a yield of about 8%; by doubling the downside exposure to 2X, the issuer of this note was able to double the yield to 16.5%.
Essentially, this trade pays off if markets are moderately up or down, but an absolute disaster if the market experiences a 2008 or 2002 scenario given the 2X downside.
Principal Protected Knockout
Characteristics: Investor receives principal plus a minimum 5% return; investor also receives any gains above 5% for the iShares Emerging Markets Index ETF (“EEM”) unless the fund reaches or exceeds 156% of its initial value during the lifetime of the note, in which case the investor receives only the minimum 5% return.
This would have been a good fit for an investor who wants full principal protection and doesn’t see a bull market in EEM’s future.
If EEM is up less than 56% over the 5 years, the investor gets the better of the index return or 5% – not a bad deal since the investor can sleep well at night knowing they have full principal protection. However, if the index returns more than 56%, then the investor is capped out at a 5% total return over 5 years. Similar to the 2-Sided Knock-Out we talked about, if the index does well (and mind you, not shockingly well, just averaging about 10% a year), your friends might be celebrating a nice return while you glumly look on.
Like all structured notes, the investor does not receive the dividend of the underlying security – in this case the ~1.9% dividend yield of EEM (see my earlier blog on why structured notes do not pay dividends); in contrast, this note only pays an imputed ~1% annual dividend.
As things turned out, investors who chose this structured note over a direct EEM investment are considerably ahead thus far, as EEM is down 12.4% since issuance while this note will return a minimum 5%.
Characteristics: Investor receives 12.9x upside exposure and full downside exposure to the Mexican peso/euro exchange rate.
1290% leverage is not a misprint; you could really have won big on this one. Without knowing much else about the note, a colleague of mine said “I would throw $50 on this” – perhaps enough said.
What is important to understand is that currency volatility tends to be low and forwards are steep. In this instance, forward pricing is 17% lower, meaning that the peso is expected to trade 17% lower five years from now against the Euro, making this investment a 17% loser.
However, there is quite a payoff if markets change – so if an investor had a strong feeling about Mexico or a bad feeling about Europe, he or she should consider joining my colleague.
In conclusion, these are all great examples of the limitless ability of structured notes to enable different, unique, and outright strange views on the market. They all also demonstrate the tradeoffs involved in building structured notes – there is no free lunch! Leverage, protection, and caps must all be traded off to obtain a desired investment balance. Typically, customization comes with a level of complexity – it is important to always understand all elements of a note. Check out my prior blog on what to look for before investing in a structured note. And if you see an interesting note, please forward along – perhaps it will make our next edition of Notes Gone Wild!