How A Structured Note Can Save Value Investors From A Bad Trade

Apple Structured Note Investment

Back in December 2012 I started geting interested in Apple (AAPL). The stock had fallen from $705 down to the low $500s as investors began to sour on its margins, the CEO, and the competitive landscape with Samsung launching a 5″ smartphone called the Galaxy S4.

One simple investing screen I use to find ideas is to see what stocks have fallen at least 20% in a six month period. From there I identify names to research for potential catalysts that will hopefully prove the market wrong. My thoughts on Apple were simply that they couldn’t ignore the market’s appetite for a large screen iPhone. I also thought they’d begin returning more money to shareholders given their $150 billion war chest. At then 12X earnings with double digit earnings growth and an S&P 500 at over 14X earnings, I thought Apple provided a good risk reward in the low $500s.

After dumping a good chunk of change into the markets in June of 2012, I regrettably let a remaining $40,000 sit in a low yielding money market account waiting for opportunity as the markets kept on rising. I figured keeping some money liquid would be prudent because one never knows what opportunities may arise. Apple looked enticing, but I wasn’t willing to “catch a falling knife.” There had to be an option where I could invest in Apple with lower risk, but with a decent return. Enter the Apple ELKs structured note (the link goes into more detail of how a structured note works).

THE NOT SO SAFE TRADE

My base case annual financial target continues to be 3X the risk free rate. The 10-year yield hovered around 1.8% in December 2012 with an expectation that it wouldn’t rise much higher than 2% in 2013. Hence, my 2013 financial benchmark was a conservative 5.4-6%. I’d aggressively seek all investment opportunities that provided greater than a 6% return if the risk was reasonable.

The Apple ELKs offered a 20% downside barrier and a guaranteed 3.5% return over six months if Apple closed higher than the 20% downside barrier. With the stock at $520 I thought there would be no way Apple would close below $415 come June 2013.  I remember thinking to myself I wish I had $400,000 to invest for a low risk 7% annualized return instead of just $40,000. 7 year CDs were only yielding 2% for goodness sake.

Apple actually ended up declining by more than 20% during this six month time period to my dismay. On April 18th while I was on vacation in Hawaii no less, Apple broke $400 to hit a low of $390. If Apple closed below $415 on the June 17 closing date I would lose the exact percentage decline! In other words, if Apple closed at $414.99, instead of getting my full $40,000 back, I would get only $31,990 back + the monthly dividend payments based on 3.5% over 6 months.

All of a sudden, making a lousy $1,400 coupon spread out over 6 equal payments vs. losing $8,000 or more minus the $1,400 coupon didn’t sound that great at all.

STRUCTURED NOTES PROVIDE DOWNSIDE PROTECTION

If I owned $40,000 in Apple outright at $520/share I’m not sure what I would do after the initial drop to the mid-$400s. I may still be holding on for hope, cursing my ill-timed investment. Or maybe I’d double down to $80,000 and hope the second half of 2013 and all of 2014 will bring about incredible new product offerings to get the stock moving again. What I do know is that my happiness meter would tick down a notch and that’s not good.

Because I’ve gone through so many downturns since the 1997 Asian Financial crisis, I’m very wary of investing in anything without protection. There are a lot of hot shots out there who think they can do no wrong because they began investing in 2008 and beyond with insignificant amounts of money, having never experienced a bear market. I can unequivocally tell you that their feelings of invincibility will change once a large correction hits again. It won’t be just their investments they are worried about, but their jobs and future as well.

If you’re willing to give up some upside in exchange for some downside protection, structured notes are a viable solution. The returns as stated in the prospectus bake in the fees. In other words, what you see is what you get, much like the “no cost” mortgage refinances. It’s important to accept that banks are making a spread off of you. That’s the price of doing business.

Sometimes you might not be really giving up any upside since the upside is already above your annual financial target (5.4% vs. 7% in this case). I thought there was a good chance Apple would continue to falter at $520, hence the structured note investment rather than the outright purchase of underlying shares. However, I thought there was no way in hell Apple would lose another 20% after already losing 30% unless management was completely tone deaf to the market.

It turns out that I was wrong, but ultimately right. Although the experience was somewhat worrisome, I maximized the features of the structured note to the fullest. It would have been ironically more annoying if Apple rebounded to $700 after I purchased the structured note at $520. Instead of making $15,000+ I would be stuck only making $1,400.

Structured notes are one of many ways to invest and manage your financial nut. The question is now where to invest the $41,400 to try and get a 6.6% lower risk return now that the 10-year yield has moved to 2.2%. Happy hunting!

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Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Matty O says

    That’s a close call! It’s pretty uncanny how the creators of these structured notes sometimes really get the barriers and buffers spot on. Apple looks like dead money for the summer. That might be a good thing if the market sells off. Insightful stuff on the hedging aspect of the structured note. thanks

    • says

      Definitely much, MUCH closer than I thought. It’s like passing the Series 7 exam in finance. Get a 70 (the lowest passing grade) and you are a hero ($415.01 in this case). Get a 100 and you are a schmuck (Apple rebounds to $700+).

      Risk is everywhere. There are no sure things!

  2. PensionRetirement says

    Could you provide your reasoning about why you went with a structured note of this type versus building what sounds fairly similar with options? I ask because it sounds like you could buy the downside protection via puts and make the spread from selling covered calls.

    • says

      Sure, mostly laziness and liking the offer. If there’s an investment opportunity I like, I’d rather just buy the product with the embedded fees rather than recreate the offer that may or may not be a perfect replica. It’s like changing your oil. Everybody can do it, by most don’t.

      If you’d like to help readers provide specific strikes and options to replicate this note with Apple at $431, I’m sure it folks interested in derivates for hedging purposes would love to see it. Cheers

  3. says

    I have ZERO experience with structured notes but leads me to the question of what are the fees in relation to what it would cost you to set up an options spread?

    • Financial Samurai says

      Hard to say and varies. These notes are like IPOs and banks earn underwriter fees. They average around 3%, but that is taken out before you get whatever the terms of the deal are. Then there is question of how the bank hedges out the risks and what spreads they can lock down.

      A good exercise for you would be to see how much it costs to replicate this note on your own and then compare.

  4. Dan23 says

    No consideration of the unfavorable tax status of structured notes if they provide principle protection (ordinary income)?

      • Dan23 says

        Fair enough, but I don’t think the difference is small.

        -If you have post deduction exemption ordinary income of <36K and LTCG/Div that take you to 36K, your marginal rate on an additional dollar can be 30% (vs max of 15% ltcg) as your additional income pushes ltcg out of zero percent bracket so you get hit twice
        -post deduction/exemption ordinary income of <36K and LTCG/Div do not take you over 36k even with additional income it is 10% vs 0 or 15% vs 0
        More than 36k post deduction exemption income it is 25 vs 15* 28% vs 15% which takes you up to 183k

        Basically, anywhere in that range you are paying anywhere from a 10% to a 15% difference in taxes on your ordinary income vs having the income as ltcg/div which is meaningful

        • Dan23 says

          I’m not sure if you are being snarky as my personal investment performance has no bearing on whether a likely 15% extra in taxes should be considered when you compare structured notes to some of your alternative investment choices.
          In case you actually wanted an answer, I invest predominantly in index funds and have been lucky in my investment period, but I don’t think other investment choices are invalid, just that all aspects should be considered (you shouldn’t dismiss the 15% extra in taxes on profit here, just make sure you believe that 15% you prefer this to your alternatives, either as a stand alone or in the context of your portfolio as a whole, the same way you are aware of the 3% fees and consider them worth it).
          From reading your blog, I get the impression that your spending is far lower than your passive income. If so, there should be more tolerance for variability when the outcome is higher expected returns (though risk appetite is obviously an individual thing).

          • says

            Thanks for your insights on investing in index funds. Ive got a bunch myself and definitely understand longer term holding periods for tax benefits. This post discusses structured products as an alternative investment.

            What I encourage investors to do is expand their investment horizons as each person has different financial requirements, tax rates and risk tolerances.

  5. Cee dub says

    Could you expound on the simple screen where you pull together stocks that have fallen 20%? How do you do that? I use TD Ameritrade…..thanks

  6. says

    Wow that must have been nerve wracking! Glad it worked out in the end. If I was in your shoes and had bought Apple stock straight in the market I’m sure I would have sold too soon. That’s the good upside with structured notes when they go your way. That’s nice Citibank has a lower barrier to entry. I met with Chase about opening up an investment account for structured notes before and they had much higher qualifications and not the best product offerings so I declined.

  7. says

    It looks like you made about 7% annualized on the note. You pulled in 3.5% interest and held it for about 6 months. But what was your full cost basis with fees included? If it was around 3% of the invested amount that you suggested in the comments, your annual return would be somewhere around 6.8 or 6.9% which still isn’t too bad. Probably not the best investment in this market, but pretty good for a conservative one.

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