Structured Notes Offer Upside But Risk

Over the past several years, I’ve used plenty of structured notes to accomplish various investment strategies. A structured note is simply a bond made by a company to accomplish a certain investment goal of yours.   For example, a few years ago I was bearish on the dollar vs. the BRIC (Brazil, Russia, India, & China) currencies.  I didn’t really feel like going and investing in these various currencies by investing in each one through the traditional methods.  So, investment banks such as Lehman Brothers, Barclays, JP Morgan, BNP Paribas, etc. would build these into a bond and make a spread.  I got a bond with principal protection and a whole bunch of upside and the issuing company got a fee to build the bond.  The currencies went up against the dollar, I sold my position, and everyone was happy.  They can be created to be very exotic.  For example, the one I owned gave me 650% of the return of the basket of BRIC currencies against the U.S. dollar.  That’s a lot of leverage.  Now, keep in mind that I wasn’t using leverage.  The reason I got that kind of leverage was because the options prices they used to create these were cheap at the time.  They use options and treasuries to build them.

Over the years, I’ve had these on currencies, foreign equity markets, just about everything you can think of. They are great because they allow you to do very sophisticated strategies and wrap them up in a bond where you principal is protected but you have a tremendous amount of upside.  But, one thing many investors didn’t think about when buying these was the paper they were written on.  That’s who is backing these bonds.  So, you might get the investment theme right, but the issuer incorrect.  I’ve made lots of money on these over the years.  The one case I didn’t get my money back was with Lehman Brothers.  I never dreamed (nor did anyone else) they would file for bankruptcy.  But, they did.  I did my homework by buying structured notes from a company with a very very long track record and a company that was very well respected.  But, at the end of the day, there were things the company owned I never dreamed of.  Their massive leverage caused them to fail.  

Just a few weeks before they went bankrupt, they were touting that their structured notes were 100% principal protected.  Now, us bondholders are waiting to see what we’ll get during the bankruptcy proceedings.  So, it’s very important to not only do your homework on your investment theme, but who’s making the bond for you.  Fortunately, I diversified and bought small pieces of the Lehman Brothers bond.  But, still, not a fun experience.  Every investment has risk.  Money market investors saw this a couple of months ago when a very old “conservative” money market fund went below the traditional $1 per share.  It went to $.97 per share and for the first time in a long while, money market investors didn’t get their principal back.  Risk comes in all forms and fashions.  You can have principal risk, reinvestment risk, interest rate risk, etc.  

A common company many of these notes are written on is Toyota.  Seems like a safe enough company.  It’s struggling like everyone else but it should be safe, right?  Well, they are now in jeopardy of losing their AAA/aaa status.  If that happens, the people that own bonds not only in the company Toyota but structured notes with Toyota’s backing could see their bond values fall.  I’m not saying they will lose their principal, but it’s something to watch.  If they get the downgrade and the bond values fall, it forces the bondholders to potentially have to hold their bonds longer to get their principal back.

As always, the moral of the story is to do your homework.  Everything has some kind of risk.

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