Structured Products - Current Risks in Chasing Returns

FINRA Arbitration Fraud and Suitability Attorney, Russell L. Forkey, Esq.

July, 2011:

The Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert warning investors about putting their assets into riskier and sometimes complex products that promise higher returns than more traditional investments.

With yields on many fixed-income investments at historically low levels and a volatile stock market, investors may be tempted to chase returns by investing in structured notes with principal protection, high-yield bonds, floating-rate loan funds and leveraged products.

FINRA's Investor Alert, The Grass Isn't Always Greener-Chasing Return in a Challenging Investment Environment, was prompted by significant recent inflows into investments like high-yield bond funds, floating-rate loan funds and structured retail products. High-yield bond funds had $75 billion in new sales in 2010. Floating-rate funds grew from $15 billion in 2008 to $60 billion in April 2011, and sales of structured products increased from $33 billion in 2009 to $54 billion in 2010.

"Investors should never make an investing decision solely by looking at an investment's return, whether past or projected. Higher returns come with higher risk. Investors should always look behind an investment's yield, ensure that they understand how the investment works and carefully consider its fees and risks before investing," said a FINRA Vice President for Investor Education.

While there are many ways investors could try to increase their return, The Grass Isn't Always Greener notes that many investors are turning to riskier products.

  • High-yield bonds are bonds with lower credit ratings, higher risk of default and consequently a more attractive interest rate to compensate the investor for the additional risk. While high-yield bonds can make sense in many portfolios, the higher yield may come with an increased possibility of losing money.
  • Floating-rate loan funds invest in loans extended by financial institutions to entities of below investment-grade credit quality. Companies that are extended these high interest rate loans usually have a high debt-to-equity ratio, and those loans' yields tend to be higher than investment-grade bonds. The interest rates on floating-rate loans adjust by a pre-determined spread over a reference rate, like the London Interbank Offered Rate (LIBOR). A fund that invests in floating-rate loans may be attractive in a low or rising interest rate environment because, in addition to having higher yields, the fund's interest rate increases when rates rise.
  • Structured retail products are typically unsecured debt with payoffs linked to a variety of underlying assets. These products can seem attractive to investors because they can offer higher returns and might even feature a level of principal protection, subject to the credit worthiness of the issuer. However, these products can also have significant drawbacks such as credit risk, market risk, lack of liquidity and high hidden costs.
  • Leveraged products include ETFs and mutual funds that seek to deliver multiples of a specified benchmark by increasing exposure to the benchmark through the use of derivatives. Leveraged products often "reset" daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time can differ significantly from the performance of their underlying index or benchmark.

The Grass Isn't Always Greener explains the benefits and risks of these products and includes a checklist of questions investors should ask before investing.