Structured Securities: 'Money Protecting' Investment Carries Hidden Risks

Structured securities products are bonds backed by stocks that allow investors to hedge their risks using options. The popularity of these products has surged in recent years because they can provide predictable returns in volatile stock markets. There's only one catch: They are often a bad idea for most investors.

According to the Financial Industry Regulatory Authority, more than 8,000 different retail structured products were sold last year. Many of them describe what they offer using terms such as "principal protection." That may sound comforting to shell-shocked investors looking at pummeled portfolios, but potential buyers need to read the fine print to determine exactly how much protection they are getting -- and at what price.

"In some cases you get 100% protection," Gerri Walsh, FINRA's vice president for investor education, said in an interview. "We have also seen cases where you are 10% protected."

Unlike stocks, SSPs are credit obligations of particular banks, so creditworthiness counts. Recent ratings downgrades to French banks such as Societe Generale and Credit Agricole will affect their structured notes. Bank of America's (BAC) structured note sales plunged because of this, according to Bloomberg. Morgan Stanley (MS) and Bank of America were two of the largest sellers of structured notes in 2010, the news service said.

The other major problem with SSPs is that in order to get protection against downside risk, investors limit their potential upside. They are also locked into the investment for a specified period of time; liquidating an SSP before its maturity is almost impossible because the securities don't regularly trade. Finally, there's the risk that the issuer may call the note early for reasons such as falling interest rates.

Despite their risks, despite worries that they might become Wall Street's next bubble, and despite a probe by officials in 10 states into how they are marketed, structured notes are still popular. According to data released earlier this year by the Securities and Exchange Commission, SSP sales have skyrocketed in recent years from $32 billion in 2004 to more than $100 billion in 2007.

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The SSP market cratered after the 2008 collapse of Lehman Brothers, which was a major issuer. In April, UBS (UBS) was fined $2.5 million by FINRA for allegedly misleading customers about the risks of Lehman structured notes. In recent years, they have made a comeback, rising from $34 billion in 2009 to $45 billion in 2010.

"You have all sorts of investors buying these products. ... [But] with any investment, there are good ones and bad ones," said Thomas Balcom of 1650 Wealth Management in Boca Raton, Fla., which has about one-third of its clients' portfolios in structured notes. "They are a good tool if used properly."

According to Balcom, investors get into trouble if they purchase complex SSPs that neither they nor their financial advisers understand. His firm's SSPs, which it purchases directly from banks, are pretty "plain vanilla," he says. Typical terms offer complete principal protection if an index declines by up to 10% over a 13- to 24-month period. Declines of between 10% and 20% will be covered up to 10%.

"It provides some level of market protection if the market turns south," Balcom says. "It does not protect you from all losses, but it does mitigate losses from certain asset classes."

Balcom argues that most investors should not buy SSPs on their own because of their complexity and should make sure their financial adviser is conversant with these products, too. And if you don't understand SSPs after your adviser explains them, don't buy them. No investment is worth that level of aggravation.

Motley Fool contributor Jonathan Berr does not own shares of any stocks mentioned. The Motley Fool owns shares of Bank of America.

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