Understanding Structured Derivative Products As An Investment
The best CD interest rate I can find is 2.3% for a 7-year CD offered by Bank of America at the time of this post (5/7/12). 2.3% is pretty weak, but the next best rate I’ve seen from a known institution is around 1.85% for the same duration.
I’m seeking yield to further enhance my passive income streams for financial freedom (highlights the various income streams). My current CD monthly interest income is around $2,800 a month and I’ve got some liquid cash that’s sitting in a money market account earning 0.2% interest. Let’s say that amount is $225,000 in new money to provide more clarity to the numbers.
Having $225,000 in a money market earning 0.2% interest is a lousy $400 a YEAR, which means I can’t even buy an overpriced iPad like millions of crazy rich folks are buying nowadays! The amount of money people have to spend on material things makes me so bullish about the economy. People don’t spend money they don’t have, just like I can’t drive a Ferrari Italia that I don’t own.
Everyday I keep my money in a pathetic money market is another day I’m missing out on free money. As such, I have been focused for the past couple of weeks on searching for ideal products to invest my money.
Narrowing the investment choices down to the following:
1) 2.3% 7-year CD with Bank of America. Guaranteed estimated return $5,175 a year / $431 a month and bringing my CD passive income to $3,243 a month.
2) 6-10% potential returns via peer to peer / social lending. Non guaranteed $13,500-$22,500 a year / $1,125-$1,875 a month. Have $50K ear-marked to this stream if and when the partnership comes through. But, could invest more if things work out well.
3) Structured CDs, with a guaranteed rate of 2% for the first two years and LIBOR + 1.45%. $4,500+ a year / $375+ a month.
4) Online trading via E-Trade or ScottTrade. No guarantees. + or – $40,000 a year.
5) Private equity investments. I’ve received a couple offers to invest in some start-ups in the Bay Area. 70% chance for a -100%, up to a 5-10% chance for a 500% return.
6) Rental property. Borrow at 3%, earn a rental yield of 8%. Estimated cash on cash return is 5% therefore $10,000 a year / $833 a month. Return on principal based on potential appreciation is different. Problem with rental property is that it is a PITA compared to online income or CDs.
7) Structured Notes. Similar to Structured CDs, but not FDIC guaranteed, and different return profile.
Not too narrow a list huh? The goal is to raise the $6,500 gross a month passive income to around $15,000 a month in order to have a comfortable lifestyle enough to take care of a family of four. The other goal is to have money work for me so I can focus on my business. The strictly passive income goal (excludes online and all other income) may change over time, but for now, $15,000 a month is what I’m shooting for.
If possible, please don’t get distracted by the capital amount discussed and if it helps, use whatever capital amount that makes you feel comfortable. The discussion focus should be on understanding structured products and feedback on a couple choices below.
THE FOCUS ON STRUCTURED PRODUCTS AS AN INVESTMENT OPTION
I like the dumbbell approach to investing e.g. high risk + low risk. As I looked more into Structured CDs, I’ve come to realize that structured CDs are exactly what I like! Structured CDs guarantee a minimum rate and up to $250,000 of your money back thanks to the FDIC insurance + it has an upside component to its returns based on a derivative.
Structured CD Examples:
1) A 5-year CD rate will guarantee you a 1% minimum return every year for 5-years. However, if Mitt Romney wins the 2012 Presidential election, the bank issuing the structured CD will agree to pay you 10% a year for the remaining four years!
2) A 3-year CD will guarantee you a 0.5% return for year one, a 3% return in year two, and 4% return in year three if the S&P 500 increases by 15% in year two, and at least 10% in year three. Every percent beyond 15% and 10% in years two and three will be divided 50/50 eg year two has a 19% increase, hence your 3% return gets a 2% bonus.
3) A 7 year CD will guarantee you 2% the first year, and 3.5% every year for the remaining six years so long as the CPI (inflation) index stays below 3.5%. Every 0.1% increase above CPI reduces your 3.5% rate by a commensurate 0.1% with a 2% floor.
So excited to start investing in structured CDs until I went looking for them.
I strolled over to Citibank to ask about their latest structured CD offering and to my surprise, they don’t have any! Disappointed, I asked what else they’ve got. Structured Notes of course! Structured notes are investment products that are structured by the bank for their wealth management clients. The products have Initial Public Offerings and are NOT guaranteed by the FDIC. Instead, the guarantee, if any is based on the viability of the institution and the markets.
There are a myriad of Structured Note products, and I want to focus on two that sound most interesting and ones where I am actually considering putting capital to work:
Dow Jones Principal Protection Structured Note
* Minimum investment $50,000.
* 6 year note to maturity.
* Receive 0.5% coupon per year for 6 years.
* Receive 100-110% of the upside of the Dow Jones Industrial average from day of structure (May 24, 2012 in this case). In other words, if I invest $225,000 and the DJIA is up by 20% in 6 years, I will have made a $45,000 return + 0.5% in annual interest income for the duration.
* At the end of 6 years, I get 100% of your principal back at a minimum. If we go into a horrible bear market and the DJIA goes down 30% in this time period, I get all my money back provided the market is still functional.
* Opportunity cost is 2.3% CD – 0.5% coupon = 1.8% per anum I do not invest in the 2.3% BoA 7-year CD = $300/month or $3,600 a year.
* The return on the DJIA payment is a “bullet” at the end of 6 years. In other words, all proceeds are paid at once upon maturity.
S&P 500 Buffered PLUS Structured Note
* Minimum investment $50,000.
* 2 year note to maturity.
* Receive 0% coupon over 2 years.
* Receive a 10% downside buffer based on day of offering (June 4, 2012). In other words, if after two years the S&P 500 is down 12%, I only lose 2%.
* Receive 2X the upside of the S&P 500 in two years up to 18-22%. In other words, if the S&P 500 is up 5% in year 1, my return is 10%. However, if the S&P 500 is up 30% in two years, I don’t get 60%, but a max 22%.
* Opportunity cost is 2.3% a year to -92.3% of the value of my principal if the S&P 500 goes down by 100%, which is not going to happen. Also not allowed to receive the 2% annual dividend yield the S&P 500 is currently providing.
WHICH STRUCTURED NOTE WOULD YOU CHOOSE?
I like the S&P 500 Buffered PLUS note because there’s only a two year lock-up and has a nice 10% downside protection before I start losing money. My bogie for market returns a year is 3X the 10-year bond yield = ~6% at the moment. If I can get 2X that return, that yields 12%, which is on par to earn a max two-year return of 18-22%. Although my bogie is 3X the risk free rate, I’m really always shooting for a 10% per anum return.
The Dow Jones structured note is also attractive because it proves a 0.5% coupon while I wait, returns all my money at the end of 6 years even if the markets go down, and gives me 100%-110% of the upside. I’m a long-term investor, and if I can find a product that I like, the longer to maturity the better! The downside is if I do need to tap the $225,000 in capital, I would have to sell the note at a loss. There are no penalties, just the market rate for the note, as a large value of the note is time.
BEFORE YOU INVEST IN STRUCTURED PRODUCTS
* Understand yourself. You need to first understand your risk tolerance, income generating abilities, and capital needs. My preliminary requirements are that I want a minimum guarantee return of all my money back (principal protection), with a minimum 30% optionality of up to 15% on the upside, for as long a duration as possible. Doing the math, If I can get a risk adjusted total expected return on my structured product of anywhere between 4-10%, I am a very happy camper because I expect inflation to be well contained.
* Understand the product. Make sure you have the banker explain everything in as much detail as possible. Ask for the downside risk and upside risk. Ask them to provide you examples of various return scenarios. Make sure you understand everything before you lock or invest your money away. Spend time reading the entire prospectus for structured notes!
* Focus on big institutions. I’m sticking with the big banks like Citibank, Bank of America, Wells Fargo, USAA, and Chase because: 1) They are too big to fail, and 2) I already bank with many of them, hence have more leverage. These aren’t fly by night banks, so I feel confident they will be around, or be bailed out by the government if they get in trouble.
* Everything is negotiable. Don’t take everything at face value. Ask for a better rate, or a better product. There is always something for everybody. I suggest you come in with as large a war chest as possible, but keep the amount hidden. The more money you have, the better concessions they will give you. They will always ask how much you are thinking of investing. Start with their minimum… perhaps $10,000, and work your way up by asking with each increment what more you can get in return. When you anchor low with $10,000, and start speaking about $100,000 at the end of the conversation, the bankers will really start bending over backwards for you.
* Get motivated to earn more money. The banker’s minimum investment to open a structured product investment is $50,000 if I invest $100,000. Clearly the banker has incentive to bring in as much money as possible to earn a commission (1-3% of principal). The point is, these products will only be offered to a minority of people because the banker only has so much time and is not going to open 100, $1,000 accounts when he can open 1, $100,000 account. Having a cash hoard gives you optionality to invest in potentially superior investment returns.
Update: I ended up investing $150,000 in the DJIA structured note and $75,000 in the S&P500 structured note $225,000 in June, 2012. I would not have invested as much in the markets if there wasn’t a downside protection component.
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