Regulators Urge Investors to Be Cautious with "Structured Notes"

June 2, 2011

Regulators warned investors to learn more about the risks associated with "structured notes with principal protection" before investing. Demand for these notes has soared as investors seek out higher yields, these "protected" products are not risk-free.

Regulators warned investors to learn more about the risks associated with “structured notes with principal protection” before investing in them. While demand for these notes has soared as investors seek out higher yields, these “protected” products are not risk-free, according to the U.S. Securities and Exchange Commission (SEC) and Wall Street’s own watchdog group FINRA.

"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 a statement.

Structured notes with principal protection typically combine a zero-coupon bond -- which pays no interest until the bond matures -- with an derivative product whose return is linked to an underlying asset, debt obligation, commodity, market index, or spreads between interest rates, to name a few. Investors who hold structured notes until maturity typically get back at least some of their investment, even if the underlying asset, index or commodity declines, according to the SEC. But protection levels vary, with some of these products guaranteeing as little as 10% -- and any guarantee is only as good as the financial strength of the company that makes that promise.

Clients of Swiss banking giant UBS AG found out how risky structured notes can be the hard way soon after the financial crisis unfolded in 2008. UBS advisors sold investors structured notes it called “100 percent principal protected notes” that were in fact unsecured debt obligations of Lehman Brothers Holdings Inc. When the brokerage firm filed for bankruptcy in September 2008, the notes became virtually worthless.

“The sales pitches were that it’s good for retirement accounts, and good for the safe, fixed-income part of people's portfolios as an alternative to owning stocks, because it's less risky,” Seth Lipner, a lawyer in Garden City, N.Y., told Bloomberg News. Lipner was hired by two holders of Lehman notes sold by UBS, including a 65-year-old accountant who lost $1.4 million. “Of course, it turned out to be more risky,” he added.

In addition to the potential risks, regulators urged investors to educate themselves on how the terms of the notes before investing. “FINRA and the SEC's Office of Investor Education and Advocacy are advising investors that structured notes with principal protection can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth,” regulators said in a statement. “Additionally, investors considering these notes should be aware that they could tie up their principal for upwards of a decade with the possibility of no profit on their initial investment.”

The warning from regulators comes as demand for U.S. structured notes linked to interest rates have soared. Banks sold $3.6 billion of the securities in May, according to a report by Bloomberg News, up from $3.1 billion in April. Sales of interest-linked notes are up 38% this year to $4.04 billion.

"The current low interest rate environment might make the potentially higher yields offered by structured notes with principal protection enticing to investors," said FINRA Senior Vice President for Investor Education John Gannon. "But 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."

To learn more about how structured notes work, and what the potential risks are, see the SEC’s helpful primer “Structured Notes with Principal Protection: Note the Terms of Your Investment.”