Structured Products

Basic reverse convertibles are notes whose repayment of principal is linked to the reference asset's lowest value during the note's term. If the reference asset's value falls below a pre-specified level during the term of the note, investors receive substantially less than the note's face value. Basic reverse convertibles tend to pay higher coupon rates than traditional notes because they expose investors to much more risk than traditional notes.



A common basic reverse convertible has the same payoffs as an unsecured note issued by the brokerage firm and a contingent at-the-money short put option on the reference asset. If the reference asset's value falls below a threshold or "trigger" price at any point during the term of the note, the contingent put option is activated and the reverse convertible note will pay the lesser of the face value of the note and the market value of the number of shares of the reference asset which could have been purchased on the note's pricing date with the note's face value. If the reference asset's value never drops below the trigger price, the reverse convertible note will pay investors the face value of the note at maturity.

Some brokerage firms issued "enhanced" reverse convertibles that exposed investors to both the downside risk and the appreciation potential of the reference asset if the trigger was breached. Such "enhanced" reverse convertibles include ELKS®, issued by Morgan Stanley, and some Yield Optimization Notes with Contingent Protection issued by UBS.

These "enhanced" reverse convertibles appear to be more valuable than the other basic reverse convertibles because the payoff at maturity isn't capped if the note converts into the reference asset. However, this advantage is illusory. It is unlikely that once the underlying security's value drops below the trigger level it will rebound back above the initial level during the remaining term of the note.



Basic reverse convertibles have been sold by many different brokerage firms including JP Morgan, Barclays, Citigroup, Morgan Stanley, Wachovia, Lehman Brothers, Royal Bank of Canada, and ABN Amro. Although many firms have branded their reverse convertibles, most are similar in structure. Table 1 lists a few of the names under which basic reverse convertibles have been sold by various brokerage firms.



Single observation reverse convertibles pay a fixed positive return if the pre-specified trigger is not breached on the note's final valuation date, and a lesser amount if the trigger is breached. Whereas basic reverse convertibles use the reference asset's lowest value to determine if the trigger has been breached, single observation reverse convertibles use the reference asset's value on the note's final valuation date. All single observation reverse convertibles expose investors to the potential losses of the reference asset.

Single observation reverse convertibles cover a broad range of structured products. For example, some single observation reverse convertibles use coupon payments to compensate investors for bearing risk, while others use exposure to a limited portion of the reference asset's capital appreciation.



Single observation reverse convertibles that pay coupons to compensate investors for bearing risk are quite similar to basic reverse convertibles. Neither type of reverse convertible offers exposure to the reference asset's capital appreciation, and both expose investors to all of the reference asset's capital depreciation if a trigger is breached.

The only difference is that basic reverse convertibles compare the reference asset's lowest value to the trigger level, while single observation reverse convertibles compare the reference asset's final value to the trigger level.

This type of single observation reverse convertibles includes Yield Optimization Notes with Contingent Protection and Buffered Reverse Convertible Notes. The maturity payoffs to these single observation reverse convertibles are similar to the payoffs of an unsecured coupon-bearing note combined with a contingent short put option on the reference asset.

Single observation reverse convertibles that use small exposure to the reference asset's capital appreciation to compensate investors for the risk of loss have payoffs exactly like a zero-coupon, unsecured note issued by the brokerage firm and three options on the reference asset: a short put option, a long call option, and a short call option. This type of single observation reverse convertibles include some PLUS and Buffered PLUS, Buffered SuperTrack and Buffered iSuperTrack notes, Performance Securities with Contingent Protection, and Return Optimization Securities with Contingent Protection.



Table 2 lists a few of the single observation reverse convertibles which have been sold under different brand names by various brokerage firms.



Autocallable securities are a type of reverse convertible. Autocallable securities have one or more call dates on which the structured product must be called by the issuer at a pre-specified premium if the reference asset's value has crossed a pre-specified "trigger." The call dates tend to be contract anniversaries and the premiums to face value paid when the security is called increase with successive call dates.



If the product is not called, the payoff at maturity exposes the investor to the reference asset's risk of capital loss without offering any exposure to the reference asset's capital appreciation.

Some autocallable reverse convertibles' payoffs at maturity depend on the reference asset's value on the note's final valuation date, while others depend on the reference asset's lowest value during the note's term.

The maturity payoffs to some autocallable reverse convertibles are not reduced below the face value by the full percentage decline in the reference asset's value. The size of this buffer can vary significantly.



Table 3 lists a few of the autocallable reverse convertibles which have been sold under different brand names by various brokerage firms.

"Tracking Securities" are notes whose maturity payoffs track the price appreciation or depreciation of the reference asset. Tracking securities do not pay coupons. Instead, at maturity they pay investors a multiple of the reference asset's gains or losses. If the reference asset loses value, the notes return less than their face value.

The basic tracking security has a maturity payoff that is similar to the return to a forward contract on the reference asset. Many tracking securities expose investors to more than 100% of the reference asset's price appreciation, which is equivalent to including an at-the-money call option with the forward contract.



It also has the same payoff as a zero-coupon, unsecured subordinated note issued by the brokerage firm, an at-the-money long call option on the reference asset, and an at-the-money short put option on the reference asset.



Portfolios with many tracking securities essentially provide investors with exposure similar to an equity index fund, but with much less liquidity and much higher costs.

Some Tracking Securities provide "buffers," or limited protection from a decline in the reference asset's value. Generally, the buffers "guarantee" a loss of no more than 100% minus the buffer amount.

It is common for Tracking Securities to be sold under branded names. Table 4 lists a few of the tracking securities which have been sold under different brand names by various brokerage firms.

Principal protected notes (PPNs) are notes which promise maturity payoffs of at least the face value of the note. Principal protected notes typically do not pay interest coupons but instead pay more than the face value of the note at maturity if the value of the reference asset increases over the term of the note. If the reference asset has a positive return over the term of the note, at the note's maturity the note pays investors the face value plus a positive return. If the reference asset has a zero or negative return over the term of the note, the note pays only the face value to the investor.



The simplest principal protected notes have payoffs at maturity which are very similar to the payoffs to a combination of a zero-coupon unsecured subordinated note issued by the brokerage firm and a call option on the reference asset. Basic PPNs are most frequently linked to a stock index or basket of stock indexes.

Absolute Return Barrier Notes (ARBNs) are PPNs that return the face value at maturity if the reference asset's value has ever closed outside of a specified range during the term of the note. If the reference asset's daily value has never been outside the range, the ARBN pays the face value plus the absolute value of the reference asset's return. ARBNs are frequently linked to commodities and exchange rates.



Many PPNs are linked to interest rates and pay periodic coupons. STEEPENERS, for instance, pay coupons that depend on the difference between two yields of different maturities. Range Accrual Notes pay coupons that depend on what fraction of the days in a quarter a particular relationship between yields holds.

A few PPNs have maturity payoffs in excess of the face value of the note only if the reference asset has lost value during the term of the note. These are still PPNs though, as their defining feature is that they pay at least the face value of the note at maturity with any additional payments depending on the reference asset's value.

The "Principal Protected" label is almost always misused in structured product marketing materials. The principal in a "principal protected" structured product is typically "protected" or "guaranteed" to exactly the same degree as the principal in an unsecured subordinated note issued by the brokerage firm is protected or guaranteed. The terms "principal protected" and "guaranteed return of principal," combined with the superfluous complexity of the coupon payment formulas, were effective at masking the substantial credit risk in structured products, especially during the financial crises of 2008-2009.

Because principal protected notes purport to guarantee principal, they are easy to market to investors seeking low-risk investments. The "100% Principal Protection Notes" name is a misleading name which makes it easy to neglect the credit risk and liquidity risk inherent in the notes.

Principal Protected Notes have been sold under different names by different brokerage firms. Table 5 lists a few of the basic PPNs which have been sold under different brand names by various brokerage firms.