Let’s learn how a structure note works. In CD Investment Alternatives, I touch upon structured notes as a potential CD replacement. Structured notes are riskier than CDs given CDs have a $250,000 FDIC guarantee per individual. That said, it looks like there is some interest in structured notes based upon the comments.
Let me first clear any misunderstanding that you need to be really wealthy to buy structured notes. Your private wealth manager will probably want you to come with $100,000 in investable assets, but $50,000 or even $25,000 will do if they see potential for a long term relationship.
Most of the mega banks like Citibank, Bank of America, Wells Fargo, and Chase have someone in a branch who can open an account for you. My account has a running cost of $50 a year with unlimited trades so it’s not expensive at all.
After we went through a harrowing March 2020, when the S&P 500 declined by 32%, and some stocks declined by 40%+, it’s only natural to look for ways to hedge. See: How To Predict A Stock Market Bottom Like Nostradamus
Let me use an Apple structured note as an example for how this works.
Example Of How A Structured Note Works: APPLE SINGLE OBSERVATION EQUITY LINKED SECURITIES (ELKS)
On December 17, 2012 (when w were just coming out of the crisis), I decided to buy $40,000 worth of Apple ELKS instead of lock it up in a 2% yielding CD for 7 years. Apple was already down about $200 points from its $708 high and I felt the risk reward was to the upside at 12X earnings. With the stock now at ~$440, this trade has proven to be mistimed, or has it?
When a stock is on a downward trend, the chances of an investor picking the exact bottom is slim. It’s a fools game really. If you are a value investor with a long enough time horizon, you set a valuation level which is deemed attractive and start legging in. I had no delusion of being able to pick the bottom at the time of purchase. My sole goal was to beat a 2% yielding CD in a relatively safe way without having to tie up my money for a long period of time.
Terms of the Apple Structured Note:
Coupon: The coupon ended up being 3.5% for the six month note (7% annualized). The 3.5% coupon is paid out equally over six months e.g. 0.583% coupon a month.
Duration: Six months from pricing date = June 17, 2013 when I can reinvest the proceeds elsewhere.
Protection Threshold: 20% downside protection to receive 100% of principal investment back. At a $510 strike, 20% downside equals $408. So long as Apple is above $408 on the maturity date of June 17, 2013, I will get all $40,000 invested back. If Apple closes below $408, I will get back exactly how much the stock is down from strike e.g. stock -50%, my principal upon maturity is cut in half.
Upside: A 3.5% six month return in exchange for 20% downside protection.
PRICING SCENARIOS FOR AN APPLE STRUCTURED NOTE
Coupon payment: As you can see from the chart, the investor will get a 3% coupon payment over 6 months no matter the performance of Apple’s share price.
Principal received upon maturity: The downside threshold in this example is $472. If the Apple unfortunately closes at $471.94 at maturity, you do not get 100% of your principal back. If Apple closes exactly at $472 or above, you do get 100% of your principal back.
* The underwriters at the time were using $590 as an example to write up the prospectus. By the time I got the prospectus, the stock had already fallen to the $500-$520 range. Examples in a prospectus give a savvy investor some edge into how a particular offering is structured.
INVESTMENT THOUGHT PROCESS
With the investment framework laid out, I’d like you to think for a moment how you should think about Apple stock before I mention my own thoughts. OK, done? Let me share with you what I was thinking back in December, 2012.
- I like Apple because it trades at a reasonable 12X multiple / 8X ex-cash with 15-20% growth, has more than $130 billion in cash, and has a proven track record for innovation and execution.
- Despite my interest in Apple, the stock is in a downtrend and I cannot pick the inflection point.
- I’m looking to find a higher return on my money market and CD investments that yield at most 2.1% for a seven year lock up period.
- I did not think after a 28% fall from its $708 high that Apple would fall another 20%.
- Even if Apple does breach $408 sometime during the 6 month note, I believe investors will get back into Apple and drive the price above $408 by June 17, 2013 given anything less puts the stock on less than 10X lowered earnings. We should see a flurry of value and growth investors step back in.
- If Apple closes higher than my $510 strike price, say $600, I’ll actually be kicking myself for not buying Apple stock outright.
- The ideal scenario is Apple closing at maturity down 20% to $408, and no worse. The structured note saves me from a 20% loss and provides me a 3.5% coupon instead for a 23.5% swing.
SINGLE STOCK STRUCTURED NOTES ARE NOT FOR THE FAINT OF HEART
With Apple down 12% post disappointing quarterly results, I’ve only got a 8.5% barrier left to $408. Does this worry me? Absolutely. But, as I wrote in my last bullet point above, the ideal scenario is if Apple lingers -20% to flat from strike price.
Worst case Apple stock goes to $0 and I collect a 3.5% coupon on $40,000 for a total loss of $38,600. With over $130/share in cash, -70% is the realistic lowest Apple can tank from here.
Buying a structured note on a single stock, especially a tech stock is much more volatile than buying structured notes on major indices such as the Dow Jones or S&P 500. This is where the large majority of my structured investments lie.
I hope you’ve found this example useful in explaining how a single stock structured note works. Now it’s time for everybody to go buy several iPhones, iPads, and $1,799 13″ Macbook Pros to help ensure Apple doesn’t close below $408 by June 17, 2013! All the kids who hardly make anything are buying the latest gadgets, so should you.
With the stock market at all-time highs, more people are investing in structured notes to protect the downside while still participating in the upside. Hopefully, the China Evergrande property stock contagion won’t hit too badly.
Related posts on structured notes:
RECOMMENDATIONS TO BUILD WEALTH
Manage Your Finances In One Place. The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize.
Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month.
The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying!
Personal Capital also has the best Retirement Planning Calculator around, using your real data to run thousands of algorithms to see what your probability is for retirement success. Once you register, simply click the Advisor Tolls and Investing tab on the top right and then click Retirement Planner.
There’s no better free tool online to help you track your net worth, minimize investment expenses, and manage your wealth. Why gamble with your future?
Invest In Real Estate
In addition to investing in structured notes, diversify your net worth and your investments with real estate. Real estate is a core asset class that has proven to build long-term wealth for Americans. Real estate is a tangible asset that provides utility and a steady stream of income if you own rental properties. If you want less volatility, real estate is more stable than stocks.
Given interest rates have come way down, the value of rental income has gone way up. The reason why is because it now takes a lot more capital to generate the same amount of risk-adjusted income. Yet, real estate prices have not reflected this reality yet, hence the opportunity.
Take a look at my two favorite real estate crowdfunding platforms that are both free to sign up and explore:
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Follow my 401k savings by age guide. But in the meantime, also build a passive income portfolio so you can live a better life today.
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 $250,000 a year in passive income largely thanks to real estate crowdfunding. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.