5 Reasons Why You Should Never Ever Buy A Structured Note

Morgan Stanley, Goldman Sachs and second-tier full service brokerages make a real market in structured notes. So-called "structured notes" are intricate products that carry the possibility of earning a much higher interest rate that a savings or money market account or even a certificate of deposit, but also bear the risk of earning nothing on your cash over extremely long periods of time.

The reasons why brokerages push these instruments are very clear. Their base product (access to markets, advisory) has been proven to lack any compelling characteristics for a generation. Online brokers, such as Schwab, ETrade, Ally Invest offer access at a fraction the cost (sometimes at no cost) and provide access to research that is just as compelling.

Against the backdrop of a marketplace that has become anachronistic, these full service brokers have tried to maintain their upper middle class clientele by offering them compelling debt products. Until the last decade, they managed to hang on to a rather brisk business in municipal bonds. Yields on municipal bonds have fallen dramatically over the last decade making them less sexy, and, unless Trump is soundly defeated, many municipalities face certain bankruptcy, leaving municipals neither sexy nor appropriate investments.

What did become sexy is a structured note. This is where, for example, your broker calls you and says: “I can get you into an offering from JP Morgan Chase that yields up to 10% a year. It is based on the spread between the 2-year Treasury and the 30-year Treasury and it gives you 5x that spread.” And, that sounds especially intoxicating when even the best savings and money market rates are less than one percent.

But, here is why you should hang up on your broker:

1.The maturity on these things is usually between 15 and 20 years (sometimes longer). You will be illiquid during that entire time. Whereas you can ordinarily get out of a CD for a small penalty, these instruments can and do trade well below par (sometimes as low as half of par). Brokers make a killing on controlling a secondary market for these and are counting on your need to get out before maturity.

2. No matter what your broker says or is instructed to say on the phone, these are not based on Treasury rates. They are based on some obscure measure listed on some back page of Bloomberg that can be easily manipulated for the issuer or made to go away. For many years, these were issued based on CMS and then they made CMS go away. Read the prospectus, read it carefully, and then assume someone is trying to screw with you.

3. Structured Notes are a tax nightmare. If you read the prospectus on these instruments, you will see that your broker is ordinarily getting a 3.50% commission on the sale of these notes and you may think that is harmless enough, but the problem is that your basis is 96.50% of what you think it is, and you are going to be taxed on the difference between that amount and 100% over time. That tax is called original issue discount and it shows up as on your 1099 every year that you own one of these things. And, that is just the beginning. There are all sorts of other ways that you can have imputed income and be taxed on it with these things.

4. If you die before these mature, you are creating a nightmare for your executor. To boot, your heirs are going to see a fraction of what you have invested in these things (see point 1 above).

5. Nobody should ever buy a friend. Your broker has entered into a profession that is heading towards obsolescence. A 3.50% commission on the sale of one of these instruments may enable them to meet their mortgage payment next month and you may feel good about that, but you are going to own these things long after your friendship has ended. And, your financial wellbeing is not out making friends.

The bottom line: I am speaking from experience here. Even though I was trained as a tax attorney, the multiple courses that I took in pricing of fixed income at Columbia Business School, I got roped into these things. They are a disaster.