When the Structure Breaks Down

The free fall in Apple’s share price has been documented ad nauseam by the financial media in recent weeks.  But how has it impacted fixed income investors?Apple bite

This weekend’s Wall Street Journal (subscribers) features an interesting case study that details how investors in income-generating “structured products” fared poorly by investing in products that are linked to Apple’s stock price.  One case in point:

 

  • UBS issues  “trigger yield optimization notes” with a face value of $700.71.
  • They mature in one year, and pay 8.03% annual interest.
  • They cost 2% to buy.
Sounds great, right?  Even for a high fee, the net interest is just north of 6% for a year, when typical short-terms bonds are paying closer to 1%.  You get your $700.71 back and pocket some solid cash.

Oh yeah, there is one other stipulation that you might have missed.  If Apple closes below $595.60 in a year, investors don’t actually get $700.71 back. They get one Apple share.  Yesterday, Apple closed at $439.88, which is a long way from $595.60.  If the stock were to close at this level at the end of the period in question, investors would lose over 30%, rather than cashing in a cool 6% in interest.

It is true that there are risks and rewards in investing.  The problem in this case is that the downside risk is high, and the upside is…pretty pedestrian.  If Apple closes at $1000 at the end of this one year period, do investors reap the benefit of that price appreciation?  No.  They earn about 6% after fees.  So they’re left with constrained upside, and unlimited downside.  Worse than than, many retail investors may not understand the downside risk.

Of course, written disclosures make clear the fact that the risks are substantial. At least one investor understood it differently this case, though, assuming that the worst case would be to break even on the investment.

Two important investing principles are in evidence in this case study:

  1. If it seems too good to be true, it undoubtedly is.
  2. If you don’t thoroughly understand what you’re buying, don’t buy it.
Note:  these products are sold by investment banks, not Apple.  If you’re still a rabid Windows fan who owns a Samsung Galaxy, feel free to continue disliking Apple.  Don’t let the actions of Wall Street steer you away from that iPhone 5 purchase, though.

 

About Kevin O'Reilly, CFP®

Kevin O'Reilly, CFP®, is a financial advisor who specializes in working with parents of twins and triplets. Have a financial question? Ask Kevin!

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