STRUCTURED “PACKAGED” PRODUCTS
The U.S. Securities and Exchange Commission has a rule regarding certain prospectus deliveries. Rule 434 of the Securities Act of 1933 defines structured securities as “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor’s investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows.”
Structured products are a group of “packaged” issues that are designed to accomplish certain objectives unavailable through conventional product offerings. As they comprise products from different markets, they are also known as “market-linked investments” or “market-linked products.” Structured products are custom made to suit a particular purpose and therefore do not have a fixed format, but instead are made up of a combination of two or more products, one or more of which is a derivative. This specialization using unique features is one of the reasons that technology used in other products cannot be employed here. These products are “packaged” by the issuer, which is usually a financial institution such as a bank. They are then sold to institutions, such as hedge funds, and, depending on the price a trading unit, to the general public.
The objective will determine which products will be used in an attempt to achieve success. It may be performance-oriented products that are structured to look at longer-term investments in markets that reflect growth and volatility. The events happening in the BRIC countries (Brazil, Russia, India, and China) have been an example of such goals. The product may be structured to participate in a high-risk/return scenario using a basket of equities and option derivatives, representing the more volatile segment of the market, or simply a principal protection product that focuses on preservation of capital and earning a higher rate of return than can be obtained through the acquisition of AAA-rated debt through the use of bonds and options.
As with any investment, the objective is always at risk. If one was to consider these financial products as musical instruments, then the selection and placement of the correct instruments will go a long way to making beautiful music. Therefore the financial instruments involved are: debt products, equities, commodities, credit instruments, currencies, futures, forwards, forward rate agreements, indexes, options, other securities, and swaps. Some of these tools are applied individually while others are placed into baskets. As such, each structured product must be examined as if it is a “one and only” because it probably is.
Structured products may be called different names by different users, such as a buy/write, income writing, income enhancement, etc. A buy/write consists of a dividend-paying common stock and a call option. Let’s take a look at some examples.
Client Pete Koll is interested in investing in income-producing securities. He buys 1,000 shares of RAM common stock at 37. RAM is paying $1.00 per share per year or $0.25 per share per quarter. At its current price RAM is yielding 2.7 percent. Pete sees that there is a six-month call on RAM with a strike price of $40 trading at 1½. This is an out-of-the-money option as no one will call a stock and pay $40 per share when the stock is trading at $37. Pete decides to sell (write) ten calls (10 contracts × 100 shares per contract × 1½ = $1,500) and take in $1,500. With that one move, Pete has collected one and a half years’ worth of dividends by the next day. If all stays status quo, at the end of the six months the option will expire worthless. Pete has earned two dividend payments (2 × $0.25 = $0.50 × 1,000 shares = $500). And because the options are out of the money, Pete can do it again.
What is the downside of this strategy? First: The stock rises above $40 and gets called away. Since Pete paid $37 for the stock and had it called away at $40 he earned $3 per share times 1,000 shares = $3,000 (three years’ worth of dividends). However, in doing so, he lost his income stream and now must find a new one. Second: What if the stock rose from $37 to $100 per share or higher? Pete gave up the opportunity to profit from the capital appreciation because of the calls. The most he can earn from the capital appreciation is 3 points, from $37 to $40.
What if the stock starts to fall in value? As Pete paid $37 per share, and received 1½ points from the sale of the calls, he has a breakeven of $35½. If the stock falls below that price, Pete has a loss. What should he do? If he sells the stock, he has ten uncovered calls that expose him to market risk and further loss, hinging upon whether the stock turns and starts a run-up in value. Since the short calls are no longer covered by the stock, Pete must post margin.
As a structured product is an actual product plus one or more derivatives, in this case common stock and one derivative with a call option were used to enhance Pete’s income.
Here’s a more complicated example. Again it uses common stock, but with two option products.
If a brokerage firm, Stone, Forrest and Rivers, was to acquire 1,000 shares of Zappo Corp (ZAP) common stock at $37 per share and write (sell) ten six-month European calls on ZAP with a strike price of $40 @ 4 and at the same time buy ten six-month European put options on ZAP with a strike price of $35 @ 2, the firm could sell this package or structured product, guaranteeing the package buyer its principal investment returned as well as the possibility of earning better than 15 percent on its investment.
Here’s the formula:
|
Owns 1,000 shares of ZAP @ 37 = |
$37,000 |
|
Owns 10 puts (10 puts representing 100 shares each = 1,000 shares) strike price 35 @ 2 = |
$ 2,000 |
|
Short 10 calls (10 calls representing 100 shares each = 1,000 shares) strike price 40 @ 4 = |
($ 4,000) |
|
Total Cost |
$35,000 |
Reviewing the position:
The purpose of the position is to preserve capital while attempting to earn a profit. Stone, Forrest and Rivers owns 1,000 shares of ZAP common stock at $37 per share. At this point in the analysis, the risk of loss is $37,000. The company owns ten of the European puts at a cost of 2 points per option, which permits it to sell (put out) 1,000 shares of ZAP at $35 at the expiration of the options. Stone, Forrest and Rivers would only do this if ZAP was selling at $35 per share or below. The firm has now invested $39,000 ($37,000 cost of ZAP stock + $2,000 cost of ZAP put options), and then sells ten calls with a strike price $40 at 4 points each times 100 underlying shares times ten contracts = $4,000 received. The $4,000 they received for the calls subtracted from the $39,000 position acquisition cost nets to a cost of $35,000. Should ZAP fall in price and be below $35 per share at the time of put option expiration, the puts would be exercised and the account would be credited $35,000 in proceeds from the exercise (10 puts × 100 shares each × $35 = $35,000).
In the case where the puts would be exercised, the account paid $35,000 net for the position, minus $35,000 received from the exercise of the puts. If that outcome occurred, the investment would be intact. But what if the stock rose and was trading above $40 when the call was about to expire? SF&R sold ten out-of-the-money European call options with a strike price of $40 @ 4, which grants the call option owner the ability to buy (call in) the ZAP stock at $40 per share. (Note: the term “out-of-the-money option” refers to the relationship between the current market value of the underlying security and the strike price of the option.) With the stock being called away at $40 per share (× 1,000 shares = $40,000) there would be a $5 per share profit ($40,000 received from the exercise of the calls minus $35,000 total cost) for an annualized maximum return of 14.28 percent in six months.
If it turns out that ZAP stock was trading between $35 per share and $40 at the expiration date of the options, the options would be allowed to expire and the ZAP security liquidated. No one would call the stock in at $40 per share if it was trading for less. Had the package been sold to one of SF&R’s clients, the company would not put the stock out at $35 if it was trading above it. Therefore, the only part of the package that remains is the stock, which now has an adjusted purchase price of $35. If it was sold the proceeds from the sale would be applied to the cost and any residual would be a profit. (This example excludes expenses.)
Had the structured product been sold to a client of Stone, Forrest and Rivers, then should the stock pay a dividend during the holding period, its distribution would depend on the terms set at the time the package was originated. As Stone, Forrest and Rivers took the necessary market action to develop the structured product, the respective clearing and settlement companies, namely the Depository Trust & Clearing Corporation (DTCC) and Options Clearing Corporation, could be maintaining the positions on behalf of Stone, Forrest and Rivers so that any dividend paid on the stock would go to the broker-dealer’s account. The dividend would be paid to the broker-dealer, which would either retain it or pass it on to the client. (This example ignores all fees, commissions, etc.) However, if such a product was packaged by a bank or a broker-dealer, the issuer’s fee would be less than it would cost the client for the package if the client was to transact all parts individually.
In the above example, the European form of option was selected to remove the possibility of premature exercise by the call option owner. The American form of option could be exercised at any time during its life. Therefore, should the call owner exercise options before expiration, the owner of the package would not be in control of the position and might have to take unwanted action to protect it.
While the above example appears to be a win or breakeven situation, there are many factors, variables, and dynamics that have been frozen in time for explanatory reasons. For example, what if the stock is trading way above $40 at the end of the package’s existence, and the profit opportunity to cash in on this bonanza is lost? What value would be assigned to the three parts if the company merged or was acquired?
One of the major products sold in the structured product market is structured notes. These notes consist of a bond and a derivative product, which may be an option, a future, a swap, etc. It is the intent of the product to protect the investor’s investment and to outperform the bond itself. The note is issued for anywhere from six months to ten years. At the end of the note the issuer is supposed to pay the investor the principal amount originally paid by the investor, plus all or part of the profit made from the derivative.
Let’s look at a couple of examples and then compare them.
Example A uses an outright purchase of a bond:
A client of Stone, Forrest and Rivers, a broker-dealer, acquires a $10,000 bond that is currently trading at $9,000 for a client. The reason for the discounted price is that since the time the bond was issued, interest rates, in general, have risen. New instruments with the same or similar qualities are commanding higher interest rates, therefore this bond’s value has to be adjusted downward to compete in the market. The bond in this example is a fixed-income instrument. As interest rates rise, bond prices fall, and yields rise so that the bond remains competitive with the newer issued bonds.
The bond carries a 5 percent interest rate, which means the bond will pay $500 ($10,000 × .05 = $500 per year or $250 semiannually). If the bond position is maintained by the client until maturity and the issuer is still financially sound, the client would receive the face value of the bond ($10,000) regardless of the current interest rates. The bond is a loan obligation and must be paid in full at maturity. The owner would have received semiannual interest payments over the time the bond was owned and was maintained, less whatever interest had accrued but had not been paid to the previous owner when the buyer initially acquired the position. If during the period the bond is owned the bondholder wants to sell it, he or she is free to do so as there is a ready market for the product. Of course, during this period, the client is facing credit risk (changes to the financial worthiness of the issuer) and market risk (changes to the current or near-term interest rates). When the bond matures, the bonds are surrendered and the client receives $10,000. The client has earned $1,000 plus accrued interest.
Here’s Example B:
Broker-dealer Stone, Forrest and Rivers is assembling a structured note. The firm acquires a $10,000 bond with a current value of $9,000. The bond is paying 5 percent interest. The bond is packaged with a long (owned) call option on an index as a structured note. The note is structured so that the maturity of the bond coincides with the maturity of the structured note. The package is sold to a client for $10,000. The client has purchased a “guarantee” that the investment is safe and that there is a possibility of a greater return than by just owning the bond. Of the client’s $10,000 investment, $9,000 is used to pay for the bond, and the remaining $1,000 is applied to the purchase of the option (or other derivative). In this example, the documentation covering the structured note states that during the duration of the structured note, the client would not receive the bond’s semiannual interest payments.
In Example A, the client owns a $10,000 bond and paid $9,000 for it. At maturity the bond owner will receive par or face value of $10,000, assuming the bond issuer is in the financial position to retire the bonds. During the period of ownership, the bond owner has received the accrued periodic interest payments. While the bond owner is exposed to market and credit risk, the owner has the ability to sell the bond into a liquid market whenever it is desirable. The price he or she receives should represent the fair market value at that time. Should the bond-issuing company experience financial hardship or even bankruptcy, the bondholder would suffer a financial loss.
In Example B the investor has paid $10,000 for an instrument that is only worth $9,000 plus whatever the potentially illiquid customized derivative is valued at. He or she has also given up receiving the 5 percent periodic interest payment. The structured note would have to earn at least the 5 percent for the owner to break even, had he or she just purchased the bond by itself. However, the expectation is that the $1,000 remaining from the bond purchase ($10,000 paid versus a $9,000 bond) will be invested in a derivative that will have to outperform the bond’s return. Had the investor actually paid $10,000 for the bond, he or she would have $10,500 at the maturity of the bond, comprising the bond’s face value and two interest payments. Therefore, as the bonds issuer will pay $10,000 at its maturity, the derivative portion must have a value of better than $500 to make the effort worthwhile.
The profits that may be obtained from the derivative leg may be paid under different arrangements. Some notes pay 100 percent of the profits to the note holder, some share only under certain circumstances, and still others cap the amount to be paid, or any combination of these. The “guarantee” of principal is only applicable at the expiration of the structured note and the maturity of the bond. Therefore the return at maturity may total less than what the bondholder in Example A above would have received.
Should the note holder want to or need to close out the position, he or she may be selling into an illiquid market, or if there isn’t any market for the product, the investor may have to sell it back to the issuer, which may or may not be interested in participating. The note holder may be offered a price far below what was anticipated.
The same outcome discussed above would occur if a zero-coupon bond was employed instead of the interest-bearing instrument. As explained in the debt section, a zero-coupon bond is a bond priced to the present value of its cash flows. Over time the interest owed accrues in the value of the bond and is not paid out periodically. At maturity, the bond is worth face value. The difference between what was paid for the bond originally and its face value at maturity is the interest earned.
The fact that the principal is “guaranteed” could be a misnomer. The questions are: who is giving the guarantee, and what exactly is guaranteed? Some guarantees have caveats as to when they apply or what events would trigger the guarantee. The caveat may be that the guarantee becomes effective only if the firm files for bankruptcy, but if it merges or goes through some capital restructuring it is not applicable. The guarantee may only cover the value of the bond at purchase, which would mean that, initially, the investor would be losing $1,000. Other guarantees “kick out” if the level of the bond falls below a certain value. In addition, structured notes may be callable or able to be terminated by the issuer. The latter is especially true if the second component has an index as an underlying product. The index portion may be permitted to increase to a point or percentage. Once that point is reached, the holder of the structured note ceases to participate. The terms and conditions for termination of the agreement may include cases of bankruptcy, inability or failure to meet the obligations, or a force majeure or other unexpected event that was disclosed in the offering document, or if the value of the benchmark or referenced security falls below the requirements of the contract.
Another form of structured note is one that employs the use of an instrument that reacts contrary to interest rates. The structured note may contain an inverse floating instrument. As interest rises in the market, the interest rate paid on this instrument falls, and vice versa.
For example, a structured product contains a debt instrument yielding 5 percent and a reverse floater yielding 3 percent, for a total yield of 8 percent. Interest rates are not static; rather, they fluctuate over time. As interest rates in the market rise, debt prices are falling, and the debt instrument is now yielding 6 percent in this situation. The reverse floater would have to be yielding 2 percent for a total of 8 percent. If interest falls, and bond prices are rising, the debt instrument is now yielding 4 percent. The reverse floater would have to be yielding 4 percent in this instance.
Reverse floaters emanate from two primary sources: security issuers and financial institutions. During volatile interest periods, issues composed of a floating-rate or fixed-rate debt instrument and a reverse floating rate will trade at a higher value than a similar instrument without the reverse floating part, because the sum of the parts is greater than the whole. With a floating-rate instrument, the interest rate changes and the value (price) remains about the same; with a fixed-rate instrument the rate remains the same but the value (price) changes. Both have the same effect on the instrument’s yield. A financial institution will marry a debt instrument to a floating rate and sell the package to a client. The financial institution has sold a debt instrument that it has issued or bought for resale and enters into a swap trade, reversing the reverse floating position so that the position is neutral.
In the above example where the debt instrument was yielding 5 percent and the reverse floater was yielding 3 percent, what would happen if interest rose to where the bond had to yield 10 percent? The reverse floater is at -2 percent yield. Obviously the owner of the reverse floater is not going to turn around and begin paying the issuer interest. The structured product nomenclature would state that once interest rates rose so that the yield would have to be greater than 8 percent, the floater would cease paying and the debt instrument would remain as an 8 percent instrument.
Equity-linked notes and index-linked notes are actually debt instruments and not equities. They represent a promise from the issuer to pay the investor an amount based on a predetermined formula. They are totally unsecured as they do not have any real asset behind them. What they are is a note combined with a derivative, such as an option, issued on a referenced asset. This asset may be a stock (an equity-linked note) or an index (an index-linked note). They are acquired at a discounted price from par; therefore, the safety of the note is directly connected to the safety of the issuer. At maturity the investor is to get back par plus any gains made by the derivative.
Due to the recent financial crisis, equity-linked notes and index-linked notes are now being issued with collateral backing. Therefore, the notes could be offered as secured, partially secured, or nonsecured. As always, the value and quality of the assets supporting the note then become of concern.
Regulatory authorities are concerned that the broker-dealers selling these products make sure that their sales personnel are well aware of their complexities and have informed their prospective clients of the risk.
A reverse convertible security consists of a long (owned) zero-coupon bond and a short (sold) European-type put on an index or common stock. The option expires at the same time the zero-coupon bond matures. The rate of interest paid by the zero-coupon bond is factored into the bond’s price, and at maturity, it will be part of the maturity payment made. The premium received from the put sale is added to the final sum received, thereby offering the investor a higher rate of return.
Here’s an example:
Assume a $10,000 investment in a zero-coupon bond that is priced to yield 5 percent, and a sale of put options on $10,000 worth of Regal Corp common stock with a strike price of $50 which netted $400. At maturity of the note, the investor would get a return of 9 percent (5% interest on the bond + 4% premium on the option). If the stock drops in price and at maturity is selling below $50 per share, the investor would absorb the loss between the market value of the stock or index and the strike price of the put option.
The investor stands to make a profit of 9 percent, which is capped at that point. The price of the zero-coupon bond cannot go higher than par (face value, which is $10,000) and should Regal trade above $50 per share the option is worthless as it is out of the money (no one would put [sell] stock at $50 if it was selling at a price above $50 in the market). On the downside, the underlying stock could fall 9 percent before the investor would have a loss. The investor’s maximum loss on the put is the difference between $50 and 0 (Regal Corp is bankrupt) less the $400 premium = $4,600 per 100 shares. The owner of the European put would exercise the option and receive $50 per share for the worthless stock. In addition, the issuer of the zero-coupon bond could be in financial trouble and thus unable to retire the bond. Because of that, the investor would also lose all or most of the investment in the bond.
(The reason a European-type put was chosen was to prevent early exercise. The European form of option is only exercisable at the end of its life, whereas the American form is exercisable any time during its life.)
We have looked at the investor; now let’s look at the issuer. The issuer has structured a product consisting of a zero-coupon bond and bought a European $50 strike price put for $400 per contract. Assuming the issuer, First Continental Bank, issued a zero-coupon bond, it would have the use of the funds for free up until the bonds matured and the structured product ceased to exist, or until the client prematurely terminated the agreement. At that time, it would have to pay the interest owed. As to the put with a strike price of $50, the result ranges from a loss of $400 per contract because the option expired worthless, as Regal Corp was trading at $50 or above, to a profit of $4,600 ($5,000 [100 shares @ $50] − $400 [the price of the put] = $4,600).