Structured Notes

Most structured products fail to compensate investors enough for the risks they take on.

Given the wrenching market volatility in recent weeks, the idea of shielding your portfolio from a big decline while still being able to profit from future gains sounds mighty appealing. That's the promise of the so-called structured note, a product that's been popular with institutional investors for years.

Now Wall Street is aggressively marketing these notes to individual investors. And retail sales of structured notes are booming: They increased by 46% in 2010 to a record $49.4 billion, according to Bloomberg, and are on track to be up again sharply in 2011.

But beware: The retail versions are watered-down, overpriced imitations of the protection offered to the big guys — and may be riskier than advertised.

The retail market for structured notes with principal protection has been growing in recent years. While these products often have reassuring names that include some variant of “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms, they are not risk-free. Any promise to repay some or all of the money you invest will depend on the creditworthiness of the issuer of the note—meaning you could lose all of your money if the issuer of your note goes bankrupt. Also, some of these products have conditions to the protection or offer only partial protection, so you could lose principal even if the issuer does not go bankrupt. And you typically will receive principal protection from the issuer only if you hold your note until maturity. If you need to cash out your note before maturity, you should be aware that this might not be possible if no secondary market to sell your note exists and the issuer refuses to redeem it. Even where a secondary market exists, the note may be quite illiquid and you could receive substantially less than your purchase price.

Structured notes are customized investments that typically package together a zero-coupon bond with derivatives. The idea is to give investors upside exposure to a specific asset class — stocks, commodities, or currencies, for instance — while simultaneously providing the relative safety of a bond held to maturity. But there are a lot of potential problems hidden in the fine print.

In exchange for limiting your losses, most structured notes also cap your upside. But it can be drastically less than the market's actual gains. In one example cited by the FINRA alert, an investor will receive the market's full gain if an underlying index rises up to 40% over the life of the note. But if the index rises 41% or more, the investor's return is automatically slashed to 10%. Many structured notes are also callable, meaning the issuer can force investors to redeem them before the return gets too high. Gains can also get dinged by higher-than-usual taxes. Notes that fully protect your principal are generally taxed at ordinary income rates — which can top 30% — instead of the more favorable long-term capital gains rate of 15%.

The downside protection can also be lacking. For instance, many notes will shield your principal from mild stock losses — say, up to 10%. But if the market falls by more than that, the value of your note could tank right along with it. You'll also forfeit the principal protection if you don't hold the note to maturity. If you have to sell before then, you'll probably lose money, since there's not much of a secondary market for the notes. And if the issuer goes bankrupt, you'll be treated as an unsecured creditor and recover little, if anything, of your original investment.