Generating Investment Income, But at What Price? Structured Securities Products in Your Portfolio

Take, for example, structured securities products, or SSPs. These unconventional investment instruments have been appearing much more frequently in individual investor accounts in recent years, particularly as the interest rates on conventional bonds have fallen. The Security and Exchange Commission (SEC) estimates that total sales of SSPs in the United States rose from about $34 billion in 2009 to $45 billion in 2010. The term "structured product" typically describes a synthetic investment that consists of a bond or note combined with an underlying asset, typically an option or other derivative tied to other assets, indices, or securities. The note generates an income stream similar to a bond, however, the overall value of the SSP (including its value at maturity) is tied to the underlying derivative or security. Depending on an SSP 's particular characteristics, the presence of the underlying derivative investment can bring significant volatility and risk of capital loss. With SSPs, the potential risks, rewards, and likely investment outcomes can be much more difficult to determine because the ultimate success of the investment depends upon the complicated interplay of the note component and the underlying investment, which, itself, is often a derivative investment that derives its value from yet another security, index, or investment. Take, for example, a particular SSP known as a reverse convertible note. In creating a reverse convertible note, ABC Financial Corp. may sell an investor a $1,000 three-month note and agree to pay the investor 1% interest per month until the note matures, similar to a corporate bond. Unlike a corporate bond, however, the reverse convertible note is linked to an underlying derivative or stock investment, say 100 shares of XYZ Co. At maturity, the investor's payoff on the reverse convertible note depends upon what happens to XYZ Co. stock while he holds the note. If the stock retains most of its value or appreciates, then the investor will have his initial investment returned in cash, just like when a corporate bond matures and the principal is repaid. If, however, the stock value falls below a certain predetermined level (say 20%), then the conversion is triggered and the investor receives the shares of XYZ Co. (or the cash equivalent) instead of having his initial capital investment returned. In its review of the retail SSP business of 11 different broker-dealers, the OCIE observed a number of "deficiencies and weaknesses,