Do you want downside investment protection? We could be in another financial bubble. But nobody really knows when a correction will take place. Therefore, may I suggest looking into structured notes.
You might not even care if your investments decline by 20% or more over a year time frame if you are looking to invest over the next several decades. But alas, none of us will live forever, and nobody really likes to experience downside volatility.
Sooner or later, we'll have to deploy our capital for life, leisure, and charity. Not everybody wants to leave a financial legacy to raise spoiled kids!
One of the strategies I've taken to protect against downside risk is to buy various structured notes based on different indices like the S&P 500, Euro Stoxx 50, and the Russell 2000, or buy single stock structured notes of specific companies. Not only do I regularly rebalance my portfolios, I also consistently dollar cost average every month. You'll be surprised how big a fortune you can create after just 10 years by methodically applying these two financial practices.
Structured notes are derivative products that usually provide hedged returns. In this post, I'd like to explain to you another recent structured note I bought to help illustrate how structured notes work. I buy all my structured notes through a Citi Wealth Management account. My other investment portfolios include: a Rollover IRA, a SEP IRA, a Self-Employed 401k, and a digital wealth advisor portfolio.
Downside Investment Protection With Structured Notes
Below is the term sheet for a American Airlines structured note created by Citigroup. The offering says the buyer of such note will receive a 8.5%-9.5% annualized coupon paid quarterly over the one year duration of the non-callable note. The coupon will be paid so long as American Airlines is down no less than 25% from the date the note is offered.
The reason why I find this note attractive is because the final coupon payment is 9%. My target return for my Citi after-tax investment portfolio is 2-4X the risk free rate (4-8% a year) with relatively low risk given the portfolio size is relatively large. 9% is above my target return, and I'm relatively bullish on airlines given the decline in oil, and the strengthening dollar which should boost demand for US travel overseas, although it will hurt foreign travelers to the US. I'm also long Hawaiian Airlines as well.
Study the terms below.
Downside Investment Protection Scenario Analysis
Here's a scenario analysis chart that is contained in the American Airlines term sheet to review. So long as American Airlines is at least 75% or higher than the initial sample share price of $48, the structured note owner will receive a 8.5% coupon. If American Airlines is down more than 25% from the initial share price, then the investor will still get paid the 8.5% coupon on his investment amount, but he will also lose the actual percentage amount once the 25% downside barrier is breached e.g. AA down 50% means you'll lose $500 of your $1,000 investment, but still get $85 in coupon payments.
On the flip side, no matter how great American Airlines performs in one year, you're capped at a 8.5% return. This scenario is terrible if American Airlines surges by 40% as some investment houses predict. My current macro thinking is that we're in the second half of a bull market, and we'll be lucky to make a 10% return in the public markets e.g. S&P 500. Therefore, if I can get a 9% return with 25% downside protection, I should be aggressively investing in such a security all day long.
Of course, stocks are more volatile than indices, and each investor has a different outlook for the markets. You just have to decide where you think the market is going and invest within your investment parameters. Don't let anybody who isn't in your shoes tell you where to put your money, unless they have a fiduciary duty to be your financial advisor.
Have a look at the various scenarios below.
I believe there is a 80% chance American Airlines will return +/- 25% over the next twelve months. Given that I only believe there is a 20% chance American Airlines will decline by more than 25%, I'm willing to invest money into this note to get a high probability 9% return. If I'm wrong, then at least I will have a 9% buffer to make up for my +25% losses.
RESEARCH HIGHLIGHTS ABOUT AMERICAN AIRLINES
Here are some highlights from boutique research firm, S&P Capital IQ that was send to me by my Citi Wealth manager. I ended up investing $15,000 into this structured note, based on my normal cadence of investing $5,000 – $20,000 a month in various securities while paying off some rental mortgage debt (Related: Pay Down Debt Or Invest?). I am unwilling to go naked long American Airlines due to the stock's volatility.
- Following a 5.5% increase in 2014, we see total operating revenues rising about 1% in 2015. We expect American to remain focused on capacity discipline and is likely to raise capacity by about 2%, while we see yields up about 1% and passenger load factor falling about one to two percentage points. We see some capacity growth in 2016 leading to revenue growth accelerating to about 4%.
- We see EBITDA margins benefiting from sharply lower jet fuel costs after a recent sharp drop in oil prices. We see this more than offsetting some unit cost pressure in wages and benefits, and certain other cost categories. We see EBITDA margins of 25.0% in 2015 versus 14.9% in 2014 and 10.8% in 2013. Following higher likely depreciation charges, we see EBIT margins of 19.3% in 2015 versus 11.9% in 2014 and 8.0% in 2013. We expect some increase in jet fuel costs in 2016, leading to an EBITDA margin decline to 23.6% and EBIT margins of 18.4%
- We see 2015 EPS of $10.34, sharply higher than 2014 EPS of $5.70. For 2016, we see EPS of $9.97, with comparisons likely affected by higher fuel costs.
More Research On This Structured Airline Note
- We recently initiated coverage of American Airlines Group with a Buy recommendation. We expect the U.S. airline industry to benefit from falling oil prices, and expect demand to remain strong. While a rising dollar represents somewhat of a risk for international travel, we see that more than offset by lower travel costs for U.S. passengers in foreign markets, which we think will stimulate demand. We do think a high debt level and slower revenue growth versus peers warrants a valuation discount, but we think the current gap versus peers is too wide and find the shares attractive at recent levels.
- Risks to our 12-month target price and recommendation include higher oil prices, increased price competition or a decline in travel demand, which could be driven by a slowing of the global or U.S. economy.
- Our 12 month target price of $70 (38% upside) values the shares at an Enterprise Value to EBITDAR (EBITDA plus aircraft rent) multiple of 6X our '15 EBITDAR estimate, versus the peer average of about 7X. It is also a P/E of less than 7X our '15 EPS estimate, below the peer average of about 9X.
Giving Up Some Upside For Some Downside Investment Protection
Once you accumulate an amount of money you're happy to live on for the rest of your life, your goal is to protect it at all costs. Looking to hit triples and home runs is financially irresponsible. Instead, shoot for singles and doubles, which to me, means earning 2-4X the risk free rate of return.
Single stock structures notes tend to be riskier than index structured notes. But thanks to tremendous liquidity in the bull market, I can only find index structured notes providing 4-5% annual returns with 20% downside buffers or barriers. That's within my target return profile, but the lockup periods are generally five years. Therefore, I've decided to go a little further out on the risk curve to improve returns while shortening the lockup period.
Think of structured notes like an investment insurance option. You hope you don't have to use the insurance (the security does much better than expected), but if you do use it, you'll be sitting much prettier than those who have naked exposure.
If you don't have a regular investment contribution habit, it's time to get started. There's an endless selection of investments to choose from. Just make sure your investments are appropriate with your objectives. Don't invest in anything you don't understand either. I hope this post helps educate you on how structured notes work.
Structured Derivative Products As An Investment
Understanding How A Structured Note Works
How To Make Lots Of Money During The Next Downturn
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About the Author:
Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $300,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
35 thoughts on “Buying Structured Notes For Downside Investment Protection”
Hi Sam- we have priced notes for clients in the 9-10% range recently based on the SP500 and Russell 2000. 1year tenor. If you are interested I chatting about them shoot me a note.
This a something I was very interested in after ready your article so I did a little research. I found a couple of things for people to look out for. First if you are buying a note of a particular index the return the broker is showing you is the price index. It does not include dividends which would be the total return index. So if you bought a S@P 500 index note with 10% downside protection your really only getting about 7.5% protection because your not collecting the dividends. Another thing to consider are these notes aren’t liquid. If a person ran into a bind a needed their money back they most likely would lose a chunk of principal. If I understand these correctly they’re priced daily based on a algorithm set up by brokerage firm that’s selling the product. The consumer has no access to how they are priced daily. Also, If the numbers I looked at are correct on any 5 year index during any period of time you would have made more money close to eighty percent of the time if you just invested in the index itself.
I still like the idea in my “play money” accounts for individual stocks but if a person has a decent time horizon dollar cost averaging, with dividend reinvestment in an index fund is a much better way to build wealth.
Bill, you are correct about the lack of dividends in some structured index notes. But some structured notes do still pay dividends plus the upside and downside features. There are endless permutations of the types of notes.
I grabbed an S&P500 data set (https://github.com/datasets/s-and-p-500.git) from 1940 until now and ran the numbers for a 5 year period. Unless I made a mistake, 84% of the time (based on successive 5 year periods, separated by 1 month) you would be up an average of 61%, while 16% of the time you would be down an average of 11%. That sounds like good odds for just holding and not be capped on upside, esp if you had to give up 10% (2% div yield * 5 years) of the principal in dividends over that time. Maybe consider buying laddered shorts over time (with the dividends) to buy downside protection (leaps only seem to go out 2 years)?
Check out the follow up post: Investment Ideas At The Top Of The Market (because that’s where we are now in 2017 so far).
Funny, yes, I was also thinking of that as well. What I didn’t compute was the conditional probability, that is, given bull market of some duration, and this far in, what is the probability of a 5 year note under those circumstances (like how many bull markets have we had that have gone on for this long?). And I suspect, you are right (or at least, its not as rosy as my last stats).
I was reading your latest blog post (today’s, I think) about your 50/50 rebalance of your IRA, echoing that same concern and I may do the same. Thanks. (As an aside, I was binge reading your posts a while back and have been wanting to do this calculation for a while, just got around to doing it today (see, there is some upside to this rain)).
This is this first time I’ve heard of this. Why a structured note vs a high yield bond fund like PCI? what about it do you find more attractive?
Nice analysis. In response to your question, I put most of our “risky capital” in peer to peer lending accounts at Prosper and Lending Club. We earn 8-10% return and spread our investments in $50 increments over hundreds of loans. We do the auto invest based on our predetermined criteria.
Hey Sam I have a question for you. What age would you say is a good age to start investing? I’m currently 17 and I have about 5,000$ saved from my job that is currently sitting in a bank account getting about 0.05% interest… I was hoping to invest in stocks, mutual funds, or an IRA. Any thoughts or tips?
Nice job thinking about your financial future and saving up $5,000 by 17! The best thing you’ve got going for you is time, and the time to learn about investing. I would open up a Motif Investing account and buy one of their Horizon Motifs, which I think is free to purchase, or build your own investment portfolio of $3,000 – $5,000. In the past, when I was 17, 20 years ago, I was spending $29 for single stock trades at Charles Schwab. Now you can build a 30 position portfolio for just $9.95, so Motif has lowered the hurdle to invest for those with smaller portfolios. Rebalancing 30 positions at once only costs $4.95 as well.
You could also open an E*TRADE account and buy a S&P 500 ETF like SPY for $7.95. But, what’s MOST important for you at this age is to learn about building a portfolio, learn about risk, different sectors, economics, when to rebalance and so forth. Practicing building a portfolio early will help you immensely down the road when you have a lot more money to invest. It may also lead you towards a career in finance like it did for me.
Hey sam I need advice I know your email isn’t on here but it’s kind of private but who cares I just turned 22 years old I have one lung and have been sick a lot I just got back to full strength at attend emu university studying marketing pursuing to become a marketing manager for a Automotive company eyeing Cadillac or tesla but let’s see what happens what would you suggest if I am just starting out I know I am still quite young I am motivated to be living a comfortable living when it comes down to It.Also did you have tons of money at 23? I know what I want but I just feel like I’m behind
Interesting. Thanks for the post. I wonder if citi gets the difference of the capped gain. Let’s say AAL returns 18% Citi returns the principle and gives you a 8.5% annualized coupon. If Citi just keeps the difference, these instruments must be pretty successful for them in the current market.
Don’t think so. The issuers generally hedge out their risk. Banks and brokers are in the spread business, and less so in the prop trading business that hurt a lot of investment banks in the past.
There are always two sides to each trade!
Thanks for the options information. As I was reading this, I was winding about the options comparison as well.
For those of us without a wealth management account at it local bank, what would be a gift way to find similar investments which could be invested in from a tax deferred account such as an IRA?
Jack you can accomplish similar results by selling puts in your IRA account assuming your broker allows you too.
If not I recommend switching brokers. I use TD Ameritrade.
Yes, I love options. I am a premium seller and rarely ever buy options.
How is this different than buying Put options besides the structured note return? Both are pretty new to me so any insight is great. Thanks.
It’s the same as selling (writing) put options, rather than buying put options. The price someone pays you for the put option would be the equivalent of the structured note return.
I don’t know if you ever look at the options market to put real probabilities around possible price targets. But it’s why I love the options market, because everything can be simplified into probabilities.
You mentioned that you think that AAL will be somewhere between +/-25% over the course of the next year. So I went to the options market to see what probabilities are currently being priced in.
Current Price = $53.40 (You must had entered this early in the week)
+ 25% = $66.75
The options market is currently pricing in a 82% probability that AAL will close below $66.75 between now and January 2016 options expiration. And a 40% probability of touching this price sometime between now and expiration.
– 25% = $40.05
The options market is currently pricing in a 74% probability that AAL will close above $40.05 between now and January 2016 options expiration. And a 47% probability of touching this price sometime between now and expiration.
You really don’t need to concern yourself with the upside since you have capped your profit potential at 8.5%.
Based on the options market this new position has a probability of profit of 74%.
I like it!!!
Nice analysis Dom! Didn’t know you were such an options enthusiast. Thanks for doing that.
My strike price is $51, yesterday’s close on 4/23/2015 before AAL reported results. The stock is up today by 3.5% due to good results, therefore, my downside barrier is now around 28%.
I’m not looking for lottery picks with my mothership portfolio. I think consist contribution + 4-8% returns is a winning combination. Lottery picks are what my private equity options, investments, and business are for!
I haven’t invested in any hedge funds, but I do have money in several different structured notes. I especially like the downside protection they provide. And I like to have a mixture of mutual funds, bonds, ETFs, CDs, structured notes, etc. in my portfolio.
Sounds like the above is quite the intriguing deal. And American Airlines had great earnings today. Best of luck!
Teach me: is this not a discouraging sign that Citibank is counting on a 25% decline? or a 25% gain? I don’t know hedges, but this seems like a scary amount of volatility, which is good for this note but very bad news for many.
Good question. One tip I have for investors buying anything is to NOT look at the term sheets (including a real estate brochure). After doing a walk through and doing your company research, then compare your investment thesis to the term sheet.
If the terms are better than you though (you think the house is worth $1.5M but they are only asking $1.3m, or you think the downside barrier should be only 20% if hey offer 9% coupon), THEN you make a move.
A market maker needs to straddle the middle, like a bookie in gambling to find both sides of the trade. This is how a hopefully efficient market works. Citi wants to make this note enticing enough to get demand, make money, and make clients happy too. If they priced the note egregiously, they won’t have much repeat business for very long!
Interesting article and strategy, but it does seem less of a hedge than a bet on low volatility – in a disaster scenario, you’re out almost as much as owning the stock outright (and if it’s crazy up, you might be kicking yourself…).
The payoff seems similar to writing puts. Have you looked into that as well, or are structured notes better in your opinion (I get the theory, but don’t have investment experience with either)?
Any insights would be helpful as this is a nice tool to have in the arsenal.
Each investment is all about trying to match one’s annual and long term objectives. I want stable 4-8% growth in my mothership portfolio, therefore, I’m looking for investment ideas that will provide me such grow based on my risk.
This note might not be appropriate for someone younger who is just developing their portfolio. But for me, I’ve reached a financial figure I’m happy with, and I’d rather spend my energy trying to earn more money on my own efforts, than the efforts of others.
Of course. But I am less interested in the generalities than the specifics – you mentioned that you’re unwilling to go long AAL because of its volatility, but this feels like a bet against volatility (and you are long AAL on the extreme downside…).
This also feels like writing puts (albeit with a pretty low strike), which is a great way to earn income except for that one time it isn’t…but was wondering if you had thoughts on that (and maybe Gen Y Finance Guy can tell us which is the better investment!).
Sounds good. At the end of the day, we can opinionate about whatever someone want’s to do with their money. The most important thing is being comfortable with what you’re doing with your own money. Reward requires risk.
Hope this post helps people understand structures notes better and options for hedging against downside risk themselves in different ways.
They don’t have April 2016 options yet, so the farthest I can go out is January 2016 which have about 266 days until expiration.
Below Sam mentioned that his strike price was $51/share. So he doesn’t lose any money until the stock falls 25% (anything below $38.25).
If you look at the $38 put you can sell it for approx. $1.50 or about 4.2% Return on Risk (RoR). If we were to annualize the return to account for an additional 3 months than we would be looking at about 5.6%. However, the options market are not necessarily linear. So we really can’t do that.
If you believe markets are efficient the returns are probably pretty close to parity.
Like Sam said above it is really just a matter of choosing your instrument of choice. He seems to like structured notes.
Hope that helps.
One of the other major differences that I didn’t think about yesterday in my response to you PK was the fact that the the RoR is likely lower on the option due to structure of the note and how losses can be incurred.
At exactly -25% Sam receives his 8.5% return with no capital loss. However at -25.01% he still gets his 8.5% but he also realizes a capital loss of -25.01% for a net loss of -16.51% (the stock price would be $38.20 based on Sam’s strike of $51)
Where with the short put you would need the stock price to decline to $27.34 to incur the same -16.51% loss.
So in Sam’s structured deal he has 25% of downside protection. The short put would give you about 46% of downside protection. But you will receive a lower return because of the increased protection.
There are no free lunches.
Sam – My Euro Stoxx 50 Structured Note is up nice since I bought it last August. I believe you bought at the same time. It’s up 18% since then. Just wish I bought more. Bought some FEZ in my wife’s IRA as well.
Nice job! Europe looks like such good value vs. the US. I definitely bought a lot last year as well. China stocks and the market (FXI ETF) is rocking and rolling as well since publishing: Should I Invest In China? A Top Down And Bottom’s Up Perspective
hey sam, i’ve been hearing you talk about these for a while and am more interested in these now. i’m a little confused on the underwriting fee per security, is it $12.50 per $1,000 you invest off the top?
Good question Nick! As you know, there is no free lunch. Nobody is going to do any work for free, forever.
For this AAL note, the 1.25% fee is paid in commissions to Citibank as revenue. My wealth advisor’s actual payment is a percentage of this, about 25%. So yes, you are actually investing $987.50 instead of $1,000. When the note matures and it’s above the 25% barrier of the initial price of AAL at issuance, you receive your initial investment of $1,000 plus the 9% paid quarterly.
Essentially, the issuers of these notes basically embed the fees into the results to make things easier. If you don’t like the fees, then don’t buy. It’s as simple as that. It takes time to originate an offering.
Very interesting, where can I find a list of those products? If you think the market has peaked, that is a very good hedge….
Just walk into a large bank branch and ask to speak with their wealth manager. Every month there are several structured notes to choose from.
Don’t forget to ask about fees and risks. Always only invest in what you know and are comfortable with. Some people in the media have made structured notes out to be bad/dangerous, whereas investors invest due to the hedging.
We tend to malign things we don’t know, as it’s easier than actually taking the time to understand, hence, the purpose of this post.