Reader Asks: A Structured Note Pays 8%. Is This A Good Deal?

At Wall Street’s casino, it’s heads you break even, tails you lose.

“I am a recent retiree and my financial advisor recommended that I invest in structured investments that pay 8% but are risky. I am also on the investment committee of my temple and am wondering whether these would be good alternative to the bond funds we have in our endowment account. What do you think?”

Richard, New Jersey

My answer:

I looked at the prospectus you sent along for Morgan Stanley Contingent Income Auto-Callable Securities. The product falls in the category of structured notes, which are things that look like bonds but have unusual bets built into them. This one is a doozy.

Are you unhappy with the 2% coupon you’d get from a conventional bond? Is that why the 8% mentioned in this offering caught your eye? My heart goes out to you.

This structured note, which matures in 18 months, is really two things. It’s a bond paying a fixed annual interest rate of 8% or possibly a bit more (the exact coupon will be determined at closing Feb. 23). It’s also a trip to a casino.

If things go well for you at the casino, you get your 8% or whatever the coupon is. If things go badly, you lose the coupon and potentially a big chunk of your principal.

I can’t do justice to the formula that determines your result, since it involves three different stock indexes and Morgan Stanley needs 31 pages to describe the note. But this analogy gives you a pretty good idea:

You go to the blackjack table and get three hands dealt to you. If any one of these goes bust, you lose. Another thing is that, after the first round of cards, the dealer can call quits. Which he will do if your face-up cards look good. At that point you get your principal back but miss out on the opportunity to get the 8%-per-year payout.

Should the endowment go into something like this? That’s really two questions, and they can be answered separately.

First question: Should the endowment own some bonds, even though bond yields these days are meager? I would say yes. Bonds, especially shorter-term ones, provide stability when the stock market crashes. The recent behavior of growth stocks is a reminder that markets can crash.

Second question: Should a synagogue be visiting the blackjack table? I’ll let you and the investment committee answer that one.

Now it’s possible that you, as a retiree investing an IRA, can handle risk that would scare away an investment committee burdened with fiduciary duties. Are structured notes a good deal for you?

I don’t like structured notes. I like plain old stocks and bonds and I like exchange-traded funds that own plain old stocks and bonds. You see prices quoted every day. You pay the same prices that billionaires pay. ETFs are liquid, meaning easy to sell. Such is not the case with structured notes.

At this point I should point out that Morgan Stanley is not particularly egregious in selling complicated investment products that the world doesn’t need. All the big brokers do it. It’s how they pay their bills.

The Morgan Stanley note starts out with a value, if you want to take the broker’s word for it, of $955 per $1,000 invested. If you are skeptical, do your own assessment. For that, you’ll need to hire a roomful of statisticians and computer programmers.

Let’s say the value is $955. Then you’re effectively paying a 3% annual fee to invest money. That seems stiff to me.

You can buy a nice collection of high-grade bonds from Vanguard via shares of its Total Bond Market ETF. Annual fee: 0.035%. If you can handle risk, put only some of your money there and the rest in the Vanguard Growth ETF (fee, 0.04%). Your investing costs at Vanguard will be 80-fold lower than with that note.

If you really like gambling, throw some money into one of Cathie Wood’s crazy ETFs that buy nothing but speculative stocks (fund names start with Ark). She charges a lot more than Vanguard, but nowhere near 3%.

With a growth-stock fund from Vanguard or Ark you are taking a lot of risk, but you at least have the potential for a lot of reward. You do not have an 8% cap on your return. You do not have the blackjack dealer sweeping away all the cards if you get dealt a good hand.

Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.

Letters will be edited for clarity and brevity; only some will be selected; the answers are intended to be educational and not a substitute for professional advice.

More in the Reader Asks series:

Should I Pay Off My Mortgage?

Should I Put All My Bond Money Into TIPS?