Structured Notes & Index Linked CDs
Structured Notes and Index Linked CDs are investment products that provide a modified exposure to an underlying index. They often provide enhanced upside (sometimes subject to a cap) and/or a buffer of downside protection. They can be a way to gain market exposure in uncertain times. They are not listed on any securities exchange and an investor may not be able to sell a structured note prior to maturity. An issuer may purchase a structured note in the secondary market if you request a bid, but it is not required to do so.
Characteristics of Structured Notes
Structured notes lack liquidity. The price, if any, at which an issuer may be willing to purchase a structured note in the secondary market, if at all, may result in significant loss of principal. You must be able and willing to hold a structured note to maturity.
For structured notes, tax treatment of contingent coupons may be considered taxable ordinary income at the time the income is received. If the notes are called, sold, or mature, you will likely recognize a capital gain or loss. Capital gains are generally taxed as ordinary income when held for one year or less and are generally taxed as long-term capital gains when held for longer than a year. Please note, structured notes with fixed interest payments may have a different tax treatment.
An investment in a structured note may result in a loss. Structured notes do not provide 100% principal protection and are not insured by the FDIC or any other agency or program. Any “buffer” included in the note’s structure provides only limited downside protection against loss and applies only if the note is held to maturity. Should you invest in a buffered structured note, you will lose some of your principal investment if the reference asset declines by more than the stated buffer amount.
The potential return on some structured notes is limited to the principal amount plus interest income, if any, regardless of any appreciation of the reference asset(s), which may be significant. Structured notes are classified as senior unsecured debt. Payment on a structured note is subject to the credit risk of the issuer. Credit risk means that if the issuer were to default on payment obligations, you may not receive any amount owed under the structured note and could lose your entire principal investment.
An automatic call feature inherent in some structured notes may force a potential early maturity. Such circumstances generally result in an above-market rate of return. There is no guarantee that you will be able to reinvest the proceeds at a comparable rate of return with a similar level of risk. The potential return on a structured note is subject to market volatility and the risks associated with the reference asset(s). The return of a structured note may be zero or less than what could have been earned on a traditional fixed income security.
Characteristics of Index Linked CDs
Like traditional CDs, the index-linked variety should be considered “buy & hold” investments and should be considered to be illiquid securities. While the issuer may maintain a secondary market for their CDs, they’re not required to do so. Anyone who might be forced to sell an index-linked CD before maturity should expect that the best price they’re likely to find could be at a substantial discount to fair value, and perhaps even below par value. Index Linked CDs include an “estate liquidity” feature, more bluntly referred to as a “death put.” In the event of the death or incapacity of the CD owner, the owner’s estate can request that the CD issuer redeem the CD at its full par value.
The CDs do not pay any regular periodic interest. Holding the CDs for their full term does not assure a gain, it only assures that your original principal amount will be returned. This investment could result in zero profit. You will not receive dividends or interest paid on any underlying constituent indices.
As a general matter, holders who purchase CDs in a principal amount greater than the FDIC insurance limits will not be insured by the FDIC for the principal amount exceeding such limit. In addition, under FDIC interpretations, the “return” on the CDs over and above the par amount, is considered to be “contingent” interest, and it is not insured by the FDIC until the amount is finalized per the calculation procedure. Any amounts due on the CDs in excess of the applicable FDIC insurance limits will be subject to the credit risk of the issuing bank.
In some cases, taxpayers may be required to recognize “phantom income” annually on the CDs even though no income is paid out. Any income so recognized increases the holder’s tax basis in the CDs.
In order to be able to offer an attractive “participation rate” on the underlying index’s performance, one or more built in constraints may be included in the process of calculating the underlying index. Performance constraining devices such as averaging, periodic caps, volatility limiters and others may be incorporated into the index calculation process. Before purchasing an index linked CD, you should understand which, if any, of these methods could be impacting the underlying performance potential.
Fees and Costs
You will pay a commission when you purchase or sell a structured note or CD. As is the case with most products purchased through a primary offering, structured notes will be priced at a discount on the first day after purchase, i.e. they will initially be priced below the $1,000 original purchase price. The discount is due to the fees and costs that are embedded in the offering price of the note. The structured note will be worth less than the original purchase price immediately after issuance.
- For example, if you purchase 100 Structured Notes that mature in 5 years, which is a $100,000 investment, you will typically pay a $3,500 sales concession, approximately 3.5% of the principal invested. Each offering is priced with a different sales concession and should be verified in the prospectus.
More information about Structured products, including their initial commissions and ongoing fees and expenses, is available in the prospectus. If you are interested in obtaining a prospectus, please contact your financial advisor.