Structured Products: These Are Not Bond Substitutes

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By David Landes :

Structured Products, or equity-linked structured products - the name alone should give pause: structured for whom? And with a name like this - JPMorgan Chase & Co. Contingent Absolute Return Autocallable Optimization Securities - would you wonder what these are?

These have been created as fixed income instruments for yield-seeking individual investors. And, surprisingly, you don't have to be an " accredited investor " to buy them.

Although I have attended trader conferences that discussed structured products, have spoken with individuals and brokers who deal with them, have observed the growth of these for over seven years, and know that there are big sales commissions involved, I still didn't understand them until I was swayed into buying one involving Apple ( AAPL ) common stock, and then I read a Wall Street Journal article describing how the Apple related products cratered.

These securities are essentially bonds that can turn into stocks of other companies. The prospectus for this particular security states "Contingent Absolute Return Autocallable Optimization Securities are unsecured and unsubordinated debt securities issued by JPMorgan Chase & Co. ( JPM ) ("JPMorgan Chase") (each, a "Security" and collectively, the "Securities") linked to the performance of the common stock of a specific company (the "Underlying Stock")."

Structured products usually pay high interest, often monthly, for a period of a year or less. If the stock the products are tied to rises or stays close to its price at the time the bonds were issued, investors get all their money back, and interest, when the bonds come due.

But if the stock falls more than 20% or so, the bonds can morph into shares of the fallen stock. And, they are illiquid. Investors must hold these to maturity.

The firms structuring these and selling these, not surprisingly, gain.

In 2012, Apple shares soared and firms such as JPMorgan Chase , Morgan Stanley ( MS ), UBS ( UBS ) and Barclays ( BCS ) sold more than $722 million of these equity-linked instruments according to a Securities and Exchange Commission analysis by Securities Litigation and Consulting Group, a research firm. 450 of these were linked to Apple alone. (Most large brokerage firms structure and sell these products).

Now, because of the drop in Apple common stock, these products are 20% to 30% underwater.

Investors, including me, should have asked this question: Why would banks offer 10% interest when most one year debt is paying about 1%?

The answer - and this is what I couldn't find earlier - is that the investment banks get something in return. In the case of the Apple-linked products, it gives them a cheap way of hedging or betting that Apple stock would go down. Now, they can dump the fallen stock on investors who thought they were buying a conservative bond. And, if the investor doesn't want the stock he will sell it again.

In short, the deck is stacked against anyone buying these products.

In my case, Apple must climb about 30% for me to get all my money back. (I don't mind owning Apple and will probably keep it when it's put to me, and I did buy these with my eyes partly open as what is turning out to be an expensive experiment). Just like a "naked" put option, committing to buy the stock I don't yet own after it falls in price.

Investors could have just done the puts, but you need to sign a special trading agreement and be pre-approved. But when the option is embedded within a structured product, the selling broker doesn't need to jump these hurdles.

FINRA is said to be looking at these products and how they are sold to retail investors. And, because the conversions to equity aren't trades there is no trade confirmation. Interestingly, FINRA groups these securities within its Bonds section of market data).

As the Wall Street Journal article states "there is no such thing as high yield and low risk. Complexity always favors the seller, and the house always wins."

Disclosure: I am long [[AAPL]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also With Treasuries, It's Not About The Interest Rate on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AAPL , BCS , JPM , MS , UBS

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