On June 2, 2011, the U.S. Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) jointly issued an investor alert called “Structured Notes with Principal Protection: Note the Terms of Your Investment” to educate investors about the risks of structured notes with principal protection, and to help them understand how these complex financial products work.
The release explains that structured notes with principal protection typically combine a zero-coupon bond (which pays no interest until the bond matures) with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. The underlying asset, index or benchmark can vary widely, from commonly cited market benchmarks to currencies, commodities and spreads between interest rates. The investor is entitled to participate in a return that is linked to a specified change in the value of the underlying asset. However, investors should know that these notes might be structured in a way such that their upside exposure to the underlying asset, index or benchmark is limited or capped.
Investors who hold these notes until maturity will typically get back at least some of their investment, even if the underlying asset, index or benchmark declines. But protection levels vary, with some of these products guaranteeing as little as 10 percent — and any guarantee is only as good as the financial strength of the company that makes that promise.
“Structured notes with principal protection contain risks that may surprise many investors and can have payout structures that are difficult to understand,” said Lori J. Schock, director of the SEC’s Office of Investor Education and Advocacy, in the media statement.
“Retail investors should realize that chasing a higher yield by investing in these products could mean winding up with an expensive, risky, complex and illiquid investment,” John Gannon, Finra senior vice president for investor education, said in the statement.
UBS AG, Switzerland’s largest bank, was ordered to pay investors $8.25 million and fined $2.5 million over sales of Lehman Brothers Holdings Inc.’s principal-protected structured products, Finra said in April.
UBS “effectively misled” some investors when selling the products, the industry-funded regulator said. The Zurich-based bank was ordered to repay some investors who bought Lehman structured notes after March 2008. The securities, which were called “100% Principal-Protection Notes,” became almost worthless when Lehman filed for bankruptcy that September.
Structured notes are securities created by banks, which package debt with derivatives to offer customized bets to investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, currencies and commodities.
Structured note sales have jumped 19 percent to $21.6 billion this year, compared with the same period during last year’s record issuance, amid low interest rates.
If you have purchased or are considering the purchase of principal-protected notes, contact Jeffrey Wittenberg today at 877-352-2010.