The market crashes of 2000 to 2002(the “tech bubble”) and 2008 (the“housing bubble”), along with per-sistent market volatility during the

past “lost decade” for equities, have leftmany investors unsettled and worried. Itis no secret that economies and marketsmove in cycles, some of which are drivenby underlying economic issues and othersby events entirely unrelated to the markets.

In recent years, at least partially inresponse to increasing market volatility,structured notes have become more popu-lar with investors and their advisors.Structured notes are among the most use-ful—but also the most complex—financialinstruments that are available to retailinvestors; they can play a valuable role inmanaging risk in a client’s portfolio, butthey have the potential to create levels ofrisk that neither a client nor the client’sadvisor might fully understand. Thus, asthe dollar amount of structured notes issuedcontinues to increase, it is important forfinancial advisors to have a clear under-standing of the risks and rewards of theseincreasingly popular investment vehicles.The discussion below explains differentkinds of structured notes, their benefits andrisks, who should use them and when theyshould use them, and, most importantly,when structured notes do not representthe best option for an individual.

OverviewStructured notes are debt instruments

(bonds) issued by financial institutions, suchas J.P. Morgan, Deutsche Bank, RBC,Morgan Stanley, Credit Suisse, and othermajor banks. These notes differ from typi-cal debt instruments, however, because theirreturns are linked to an underlying equity

index—such as the Standard & Poor’s(S&P) 500; the Europe, Australia & Far East(EAFE) Index; or the Dow Jones Real EstateInvestment Trust (REIT) Index—instead ofsimply paying a stated rate of interest.Moreover, rather than being linked directlyto the index, structured notes can also belinked to an underlying indexed-linkedexchange-traded fund (ETF), such as the“Spider” (S&P’s Depository Receipt [SPDR]S&P 500 Index ETF; ticker symbol: SPY),iShares MSCI EAFE Index ETF (tickersymbol: EFA), or iShares Dow Jones RealEstate Index ETF (ticker symbol: IYR).

In order to create a structured note, abank issuer combines a zero-coupon bondwith financial derivatives, such as put andcall options or futures contracts and swapagreements. This strategic combination of

traditional investments with derivativesdetermines the investment payout at matu-rity. From a buyer’s perspective, theinternal structure of the note and the nec-essary rebalancing of its derivative com-ponents are not of concern. The buyer’sconcern is that the note and the payoffstructure of the note are guaranteed bythe issuing bank; thus, the buyer’s riskexposure is the counterparty risk that theissuing bank will be unable to pay the noteat maturity. Although this risk can be min-imized by only investing in notes issuedby financially strong banks with high cred-it ratings, it cannot be eliminated.

The more basic structured notes arereferred to as “buffered notes.” These arestructured with limited downside risk and,in return for the investor taking some risk,

F I N A N C E

m a r k e t s & i n v e s t m e n t s

SEPTEMBER 2012 / THE CPA JOURNAL50

By William G. Droms and Steven N. Strauss

Understanding the Risks and Rewards for Investors

Structured Notes in a Balanced Portfolio

SEPTEMBER 2012 / THE CPA JOURNAL 51

the payout on the upside is enhanced. Forexample, an investor might want to protectagainst the first 10% decline in the equitymarket, based upon the assumption that itis unlikely that markets would decline muchmore than 10% from current levels by thetime the note matures. In exchange for thebuyer taking on the equity risk of a declineof more than 10%, the issuer can constructa structured product that provides enhancedupside return, usually in the form of a returnmultiplier, such as two times the positivereturn earned by the selected index. Theupside is not unlimited; generally, one mightexpect a 13-month note to have a maximumreturn—that is, a “cap”—in the range of 15%to 20%, so that if the index went up by morethan the stated maximum, the return wouldbe limited. As the term of the note increas-es, the maximum stated return generallyincreases as well. Furthermore, structurednotes are generally very tax efficient—thereturn earned on a structured note (of morethan 12 months in term) is considered a long-term capital gain, which is taxed at long-termcapital gains rates.

For example, one major bank recentlyoffered an 18-month note with a 10% down-side buffer and a payment at maturity of dou-ble the increase in the value of the S&P500 from the issue date to the maturitydate, subject to a cap or maximum returnof 19.75%. With this note, the full parvalue will be paid to the bond holders if theS&P 500 has declined by 10% or less atmaturity. If the S&P 500 has declined by15%, then the first 10% decline will becovered by the buffer and the bond willpay 95% of par value at maturity. (Aninvestor would lose 5%, compared to 15%if the same funds had been invested in theS&P 500.) On the positive side, if the S&P500 has increased by 8% at maturity, thenote will pay two times the 8%—a return of16%. If the S&P 500 is up by more than9.875%, the note will cap out and pay19.75% of par value at maturity.

Risks Structured note vehicles allow investors

to maintain a particular market exposurewith some downside protection, thus reduc-ing equity volatility risk compared to justowning an underlying index fund outright;however, structured notes also have sig-nificant downside factors to consider.

Structured notes, if used appropriately, canprovide an investor with a predeterminedamount of upside potential and decreasedrisk, but they are certainly not free fromrisk. The first and most important risk toassess is the credit risk of an issuer.Structured notes are bonds backed by theissuing bank; if the issuer defaults, bondholders become unsecured creditors ofthe bank.

For example, investors who held struc-tured notes issue by Lehman Brothers in2008 saw these notes become virtuallyworthless. According to anecdotal reportsin the press, some holders of Lehman struc-tured notes had their retirement savingswiped out, under the apparent and com-pletely mistaken belief that these noteswere as safe as an annuity from a majorlife insurance company, but with a muchbetter return.

Advisors must understand the credit riskexposure of structured notes and shouldexplain this exposure to clients. This cred-it exposure is the central risk of the notes;they are unsecured notes backed only by thecreditworthiness of an issuing bank. Ineffect, using structured notes to reduce equi-ty risk trades equity risk for credit risk. Onthe other hand, structured notes carry nomore credit risk than any other unsecurednote issued by a bank; thus, they are not anyriskier than an interest-bearing note issuedby the same bank. Before investing in astructured note, investment advisors havethe same due diligence responsibilities thatthey would have in investing in any otherfixed income investment.

A second risk of structured notes is real-ly more of a disadvantage: most structurednotes do not factor dividend income intotheir return. For example, assume that theS&P 500 dividend yield is 2% per yearand that an investor holds a two-year noteindexed to the S&P 500. If the value of theindex remains unchanged at the end ofthe two-year term, the rate of return is 0%,compared with the 2% per year if theinvestor had held the underlying S&P 500.

A third risk to consider is liquidity.The secondary market for structurednotes is sometimes limited, and it can becostly to sell these notes prior to maturity.To mitigate this risk, investments in struc-tured notes should be limited to fundsthat will not be needed during the note’s

term. Even when the issuing bank main-tains a “market” for the note, theseinvestments should not be purchased unlessthe investor plans to hold them to maturi-ty. In the authors’ experience, in the veryfew circumstances where clients have hadto sell a note prior to maturity, they wereable to execute the sale at prices very closeto the value indicated on the clients’ bro-kerage statements. (The notes have aCommittee on Uniform SecuritiesIdentification Procedures [CUSIP] numberand are priced daily on clients’ brokeragestatements, just like any other corporatebond.) Regardless of their benefits, struc-tured notes may not be appropriate forclients who do not fully understand thecredit and liquidity risks involved.

A final risk to consider is income risk.If a note is structured to provide a prede-termined income payment, there is a riskthat the income payments will not be madeif the issuer defaults on the note. Income-oriented structured notes are fairly rare, butif a note is structured this way, then thisrisk must be taken into account.

RewardsIn return for their risks, structured notes

offer some downside protection and anenhanced return on the upside (subject to thecap). Using structured notes as describedabove allows investors to maintain a partic-ular market exposure with some downsideprotection, thus reducing equity volatility riskin their investment portfolio. Based uponan investors’ view of the market, structurednotes can be used to lever a return that theinvestor deems likely to occur and to pro-tect against a sell-off that the investor deemspossible to occur. Used properly as part ofa diversified portfolio, structured notes canreduce the portfolio’s equity risk andpotentially enhance total return.

The authors, in their own private wealthpractice, have limited their investments instructured notes to the “plain vanilla”buffered notes described above. They havefound these notes particularly attractive toclients during times of greater-than-normalmarket volatility. After the 2008–2009 mar-ket crash, for example, the authors con-vinced nearly all of their clients to “staythe course” with their equity investments.Part of this strategy was to emphasize theuse of structured notes as a means of hedg-

SEPTEMBER 2012 / THE CPA JOURNAL52

ing part of the downside risk of a furtherdecline in equity markets.

Structured notes appeal to some wealthmanagers because they will always outper-form their underlying indexes in a down mar-ket, due to the downside buffer, and will out-perform a rising market if the market increaseis less than the cap. In those cases wherenotes owned were capped out because of therapid rise of the stock markets followingthe March 2009 bottom, the authors receivedno expressions of concern from clients whoowned the notes that capped out. In part, thisreaction was likely caused by the widespreadfeeling of relief following the recovery of themarket in 2009 and 2010. But it is unlikelythat investors who purchased a note pri-marily as a means of hedging downsiderisk and reducing volatility would be dissat-isfied with notes that capped out when themarket happened to experience an extraor-dinary increase in a short period of time.

The returns of structured notes are afunction of market returns over the hold-ing period of the note. As mentioned ear-lier, structured notes will outperform theunderlying index in a down market, due tothe existence of the buffer. But outperformis a relative term here, and it is still possi-ble to incur a loss on a buffered note in amarket that takes a sharp downswing. Witha 10% buffered note, for example, a 20%market decline would result in a loss ofprincipal equal to 10% of the note’s parvalue. A 30% decline—certainly notunprecedented in recent experience—would result in a 20% principal loss.

In a rising market, structured notes can beexpected to outperform the underlying indexif the cap on the note is more than double(for a two-to-one levered note) the total returnon the underlying index (including the div-idend yield). For example, a two-year notewith a 16% cap will outperform the under-lying index in a period when the underly-ing index, including dividends, provides atotal return of less than an average of 8%per year. If the return on the underlying indexis greater than 8% per year, then the struc-tured note will cap out and the owner ofthe note will suffer an opportunity loss equalto the excess of the underlying return abovethe cap on the note. Thus, there is the pos-sibility of an opportunity loss on a structurednote in a robust market environment.

In addition to the plain vanilla bufferednotes, many other types of notes exist to

meet different client objectives, such asnotes indexed to volatility indexes, market-neutral notes, notes indexed to baskets ofcurrencies, and notes indexed to baskets ofcommodities. A typical market-neutral notemay be tied to a wide variety of underly-ing indexes and is structured to provide areturn equal to the percentage change,either up or down, of the underlying index.At maturity, holders of a market-neutralnote receive a payment equal to the prin-cipal value of the note, plus the absolutepercentage change in the level of the under-lying index, subject to caps at both ends(i.e., either positive or negative changesin the index), referred to as barriers. Thenote pays a percentage return equal to theabsolute value index change—as long asthe change never breaches the barrier;should it be breached at any time duringthe life of the note, the note simply payspar value at maturity. Thus, the risk of lossdue to changes in the index is zero, but thenote is still subject to counterparty risk.Because these notes offer the possibility ofpositive returns in both bullish and bear-ish markets, they are referred to as market-neutral notes.

A typical market-neutral note might have18 months to maturity with a 20% barri-er. At maturity, if the underlying index iseither up or down by 15% and the barrierhas never been breached, the note wouldpay off the par value, plus a 15% return.But if, at any time during the 18-month lifeof the note, the index closed either up ordown by 20% or more, then the note wouldsimply repay its par value at maturity.The clearest benefit of these notes can beseen in a down market, where the noteshould always outperform the underlyingindex. If the underlying index was downby 15% at the note’s maturity and thebarrier had never been breached during thelife of the note, the note would pay a pos-itive 15% return. If the market was downby 25%, the note would pay par value atmaturity for a 0% return. Receiving parvalue at maturity is obviously a muchbetter result than a 25% loss, but there isa catch: if either the lower or upper barri-er was breached at any time during the lifeof the note, the note would only pay parvalue at maturity.

On the upside, if the underlying indexwas up 20% or less at maturity, and thebarrier had never been breached, the per-

formance of the note would match the per-formance of the underlying index dollar fordollar. If the upper or lower barrier wasbreached at any time during the life of thenote, however, the return on the note wouldbe 0%—this opportunity loss is the majorcomponent of the price paid for thedownside insurance. Thus, there is a poten-tial for opportunity loss in both directions.

These market-neutral notes are attractiveprimarily as a hedge against a major mar-ket decline. Once a market-neutral notedoes breach a barrier, the owner is left witha zero-coupon bond that will pay par valueat maturity. This note can be sold in thesecondary market (at a discount) and theproceeds can either be cashed out or rein-vested in a new market-neutral note, effec-tively “restarting the clock” on a new mar-ket-neutral note. Alternately, of course, theowner can elect to simply hold the note tomaturity and receive full par value. Becausethere is no risk of loss due to changes inthe underlying index with this type of struc-tured note (although there is credit or coun-terparty risk), a market-neutral structure thatguarantees 100% principal repayment istreated for federal income tax purposes asa “contingent payment debt instrument.”

Plain vanilla and market-neutral notescan also be indexed to baskets of curren-cies or commodities. Although thesenotes are structured in a manner compara-ble to notes that are linked to underlyingstock indexes, they offer the opportunity toearn a return tied to currencies or com-modities. Beyond these notes, there existsan almost unlimited number of combina-tions and permutations of structurednotes, which can meet a wide variety ofprivate client investment objectives ifthey are used correctly.

Using Structured Notes as Part of a Balanced Portfolio

CPAs interested in recommending structured notes to clients or integratingstructured notes into a wealth managementpractice need to consider several due diligence issues in order to become com-fortable with using structured notes. Thefollowing sections examine a few majorissues that advisors should consider.

Credit quality of the issuing bank. Thisis a primary concern in evaluating a struc-tured note, just as it would be if one werebuying a plain vanilla, income-paying cor-

SEPTEMBER 2012 / THE CPA JOURNAL 53

porate bond from the same bank. If the issu-ing bank’s credit is deemed acceptable,then the credit quality underlying a struc-tured note is no more or less important thanthe credit quality of a comparable plain vanil-la bond. For example, the credit qualityissues surrounding a structured note issuedby JP Morgan Chase are no more or lessimportant than those surrounding a plainvanilla, income-paying bond issued by JPMorgan Chase. If the credit quality wouldbe deemed acceptable for a plain vanilla cor-porate bond, it should be deemed acceptablefor the structured note.

Credit rating of the issuing bank andthe cost of a credit default swap. Twoimportant inputs to assessing credit quali-ty are the ratings given by the major rat-ing agencies and the market price of a cred-it default swap (CDS) for the issuing bank.The ratings assigned by the “big three”(S&P, Moody’s, and Fitch) are a goodstarting point for evaluating relative cred-it ratings. The market prices at which CDSstrade for the banks provide an excellentadditional check on credit quality: thelower the market price to insure the bank’scredit, the higher one can judge the cred-it quality. It is often the case that bankswith similar credit ratings will have wide-ly different CDS market prices; in such acase, the issuer with the lower-priced CDSis often a better choice from the perspec-tive of seeking the highest credit quality.

Transparency issues. Structured notescan be difficult to understand because buy-ers cannot see into the “black box” ofexactly how the issuing bank is structuringand hedging the notes. But the issuer cancertainly explain the inner workings ofthe note to the buyer in sufficient detail;this way, buyers who take the time to inter-act with issuers can understand how thenote works. The bottom line is that theissuing bank is committed to providing thestructured payout that is described explic-itly in the offering prospectus.

Break-even point. Before an order isplaced, it is a good idea to calculate howhigh the underlying market would have togo for the buyer to have been better off justholding the underlying asset. For example,if a two-year note with a 16% cap is indexedto an underlying asset that has a 2% divi-dend yield and the market rises by 12% ormore over the two-year period, the under-lying asset would have provided the same

total return as the note (i.e., ignoring com-pounding, the underlying asset would appre-ciate 12% and would have earned 4% in dividends for a total return of 16%). Inassessing the attractiveness of the note, poten-tial buyers should assess the likelihood ofthe potential opportunity-cost penalty thatcould be imposed by owning the note rela-tive to the underlying asset. Of course, thisassessment also would have to take intoaccount the value of the buffer on the down-side, compared to the potential opportunityloss on the upside.

Diversification. In their practice, theauthors diversify structured notes acrossasset classes, within asset classes, andacross issuers. To limit counterparty riskand maintain diversification guidelines,they generally limit the total amount ofnotes of all categories to a maximum of6.5% of total assets, with no more than1.5% invested in any one particular issue.To diversify across asset classes, theauthors generally limit their exposure to amaximum of 3% invested in notes indexedto the U.S. stock market, a maximum of2% indexed to the EAFE Index, and amaximum of 1.5% indexed to the REITmarkets. In addition, the authors diversifyby issuer and typically own a total noteportfolio distributed across at least three orfour different issuers.

Fees involved. Structured note returns arequoted net of fees, but buyers shouldunderstand how an issuer is paid on the note.Fees are clearly stated in the prospectusand the pricing supplement accompanyingthe note; they are commonly expressed asan “all in” percentage commission paid tothe issuer, with part of that fee allocated asa selling concession to unaffiliated dealers(generally the broker-dealer who is acting ascustodian of the note). One common struc-ture is based on a one-time fee of 25 basispoints (0.25% of the face value) to the bro-ker-dealer and a distribution fee paid to thenote issuer equivalent to 50 basis points peryear (0.50% annualized) over the life of thenote. In addition, the issuer has the use ofthe note proceeds that can then be investedby the issuing bank in loans or other assets.

The fees cited are what the authors haveseen, using a discount broker that acts as cus-todian for their fee-only practice. For fee-only advisors, the fee charged on a struc-tured note as part of a client portfoliowould be the same as the advisor’s stan-

dard fee on assets under management; thus,there would be no difference between feesearned by investing in structured notes andfees earned on any other assets in the port-folio. For advisors or brokers who earn com-missions on their clients’ investments, thecommission would be included in the sell-ing concession described above; these feeswould be significantly higher than those ina fee-only practice in order to allow for thepaying of commissions to the selling bro-ker or commissioned advisor.

A Starting PointAlthough the items discussed above do

not represent an exhaustive list of majorissues, they provide a good starting point forevaluating the role that structured notes canplay in a balanced portfolio. The authorshave had a very positive response fromclients to the expanded use of structurednotes designed to reduce equity market riskin broadly diversified portfolios.

Advisors using these notes shouldemphasize the risk reduction attributes ofthe notes provided by the downsidebuffer more than the leveraged returnpotential on the upside. The authors haveowned some notes that have capped out,as well as some that outperformed the totalreturn on the underlying index on theupside due to the leverage feature. Advisorsmight want to think of the opportunity costof the notes that cap out as essentially thecost of insurance, and the outperformanceas a nice bonus in a relatively flat market(i.e., two times the return underlying is stillless than the cap). As an attractiveattribute—assuming no counterparty prob-lems—a buffered note will always out-perform a falling market.

For CPAs engaged in private wealthmanagement or personal financial planning,learning about the advantages and disad-vantages of structured notes, includingthose presented in the discussion above,would be time well spent. ❑

William G. Droms, DBA, CFA, is thePowers Professor of Finance in theMcDonough School of Business atGeorgetown University, Washington, D.C.,and a cochair of Droms Strauss AdvisorsInc., St. Louis, Mo. Steven N. Strauss,CPA/PFS, is also a cochair of DromsStrauss Advisors Inc.