Do you really understand structured products?

Business @ AsiaOne

Do you really understand structured products?
Be smart; know what you're in for
Larry Haverkamp (Doc Money)
Tue, Jul 31, 2007, The New Paper

IT is almost funny. We have invested billions of dollars in structured products, but no one seems to understand how they work.
Here's how: Equity-linked notes (ELN) promise high returns and are one of the most popular structured products. The most advertised has been Pinnacle Notes. It is now selling series 8 which will close its offer tomorrow.
It is similar to other ELNs. Your earnings are linked to eight well-known local stocks like DBS, UOB, OCBC and Singapore Press Holdings.
If the price of all eight counters declines by no more than five per cent, you earn an annual return of 8.8 per cent. It's good.

If all eight stocks decline no more than ten per cent, you get 4.8 per cent. It's still good.
For the worst case, if even one stock declines more than 10 per cent, your return drops to zero.
Structured products limit both losses and gains. For Pinnacle Notes, these range from 0 to 8.8 per cent per year for four years. It looks fair.

Dig a little deeper, however, and you'll find problems:

1. First, if the market is strong and all eight stocks remain above their launch price (LP), you will be 'knocked out' after three months. Then, you get only your principal plus 2.2 per cent interest.
2. Second, to get the full 8.8 per cent per year for four years isn't easy. ALL eight stocks must remain above 95per cent of the LP and at least one must drop to the 95 to 100 per cent range.
3. Third, if just one of the shares drops into the 90 to 95 per cent range, you get 4.8 per cent.
4. Fourth, if just one of the eight stocks falls below 90 per cent of the LP, your return falls to zero.
5. Fifth, ELNs and Pinnacle Notes do not disclose costs. Sales people may tell you there are none.Don't believe it. The costs are significant and higher costs increase the likelihood of your receiving the lower end of returns (0 per cent).
6. Sixth, Pinnacle Notes are 'principal protected'. It sounds reassuring, but the protection can be withdrawn when you need it the most, as I will explain.

PRINCIPAL PROTECTED?
Pinnacle Notes invest about 90 per cent of your money in high-rated corporate bonds and 10 per cent in options.
The options do well when the Notes' 4.8 and 8.8 per cent payout conditions are met. Otherwise, they expire worthless. That is okay since the bonds earn enough to pay expenses and repay your investment.
It gives you principal protection.

If even one bond defaults, however, the issuer can cancel your protection. It is all explained in the 242 pages of prospectus and pricing statement. It is heavy reading. Here are two key excerpts:

(i) The principal protection can be withdrawn if a bond's interest payment is late. The word 'late' is defined rather strictly in the prospectus.
It says: 'reference to any grace period will not be applicable'. (page A-26)

(ii) The pricing statement says: 'the amount the Issuer will pay back... could be significantly less than the principal amount of the Notes. Accordingly, it is possible that investors could lose all of their investment.' (page 13)

Lose your investment? What about the principal protection?
Well, it is there for you in good times. In bad times, when you need it the most, the protection can be withdrawn by the issuer.
A Pinnacle Notes salesperson explained it to me this way: 'It's not as safe as government bonds, but it is still safe.'
That brings us to the billion dollar question: If the risk of the bonds defaulting is really so small and hardly worth mentioning, why pass it on to investors?
Why doesn't the issuer avoid this matter by simply taking the risk itself?
The only answer I've received so far is: 'It's the industry practice.'
The more, the merrier? Not for these equity-linked notes
THE previous series of Pinnacle Notes, series 6 and 7, required six bonds to stay within a prescribed price range. Now, to earn a return you need eight stocks.

Normally, adding more shares to your portfolio is good. It provides diversification.
With structured products, however, the investment rules get turned on their head. Now, owning more stocks is bad.
Why? It's because the chance of six stocks staying within a given price range is somewhat of a long shot.
The chance of eight stocks doing it is even more remote.
The sales people I talked to never mentioned this.
Their focus was entirely on earning the top return of 8.8 per cent. No one said a word about the probability of achieving it.

Copyright ©2007 Singapore Press Holdings Ltd.
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