Live

Watch CBSN Live

ELKS: When fixed income isn't really fixed income

As yields have plummeted over the past few years, we're seeing more and more Wall Street firms market structured products as replacements for high-quality fixed income. Unfortunately, many investors are buying these products without either fully understanding the risks they're taking or why these products are almost always in the best interests of Wall Street, but not theirs. In this post my Alternative Investments co-author Jared Kizer takes a look at a structured product called ELKS (Equity LinKed Securities), which was introduced by a large Wall Street firm.

Like many structured products, ELKS are nothing more than a repackaging of option positions marketed as if it were fixed income. The first two questions an investor should ask before buying these products are: 1) Would any firm ever sell options to me on the cheap, or is it more likely that I'm paying more than fair value for these options? 2) Do I have any real understanding of the downside risks?

Bad Investments: Reverse Convertibles
Bad Investments: Principal Protection Notes
Bad Investments: Super Track Notes

In my experience, the answer to the first question is obvious, and most individual investors have very limited understanding of the risks of derivatives like options. One ELKS that we examined had the following features:

-- Issue date: 2/25/10
-- Maturity date: 3/29/11
-- Coupon rate: 11.50 percent a year
-- Issue price: $10 per ELKS
-- Equity ratio: 0.43029
-- Payment at maturity: If on any trading day the closing price on a specific common stock has decreased below the threshold price, then you will receive shares of the underlying equity in exchange for each ELKS in an amount equal to the equity ratio per ELKS or the cash value of such shares. Otherwise, you will receive an amount in cash equal to $10 per ELKS.

The payment at maturity language basically tells you that you've sold a complex put option on the stock of that company. This structure is just another form of what are known as reverse convertibles. The primary reason you're getting paid such a high coupon rate is because you've taken on substantial risk that you won't get back $10 per ELKS. In fact, if the stock goes down far enough, you may get a lot less than your original $10 per ELKS back.

It's unlikely that many individual investors have the skill to evaluate whether the terms of the ELKS are fair given the risks. This is also a product that you would likely never see in any portfolio managed by an institutional investor. These products are marketed to the individual investor marketplace for a reason -- studies have found that the options are typically undervalued by 3 percent or more. In the case of this particular ELKS, the yield should have been at least 14 percent to be a fair deal.

You should also be aware of the liquidity risk of a product like this. While issuers typically offer liquidity in the secondary market, there's no guarantee the liquidity will be there if you need it. There's also no guarantee the secondary price will reflect changes in the underlying price. And the bid/offer spreads can be significant. Thus, investors should treat them as a buy-and-hold investment.

If you need fixed income, make sure that what you own is truly fixed income. Structured products such as ELKS aren't really fixed income. In the case of the ELKS, you're effectively selling put options on individual stocks and getting paid some fraction of the proceeds from the sale of that option as "coupon" income.

View CBS News In