Apple, Equity-Linked Structured Products and Bondholders

A recent article in the Wall Street Journal underscores the often unforeseen impact of equity-linked structured products tied to the price of certain stock. In this case, it’s Apple.  As the article points out, investors who once had big yields on seemingly safe short-term debt will soon discover huge losses, while the firms that sold them profit.

Equity-linked structured products are issued by investment banks and essentially are bonds that can turn into stocks of other companies. They pay high interest, typically monthly, for one year or less. If the stock that the products are tied to rises or stays close to its price at the time the bonds were issued, investors get all their money back when the bonds come due.

The downside, however, is this: If the stock falls more than about 20%, the bonds can morph into shares of the fallen stock. The buyers, who are usually individual investors, must then hold the bonds until they mature.

Last year, shares of Apple stock soared, and firms such as J.P. Morgan Chase, Morgan Stanley, UBS, and Barclays sold more than $722 million of these products, according to an analysis of Securities and Exchange Commission filings by Securities Litigation and Consulting Group (SLCG), a financial research firm based in Fairfax, Va.

At least 450 new structured products were linked to Apple, according to SLCG. Three-quarters of them were issued when the stock was at least $550. Last Friday, Apple shares closed at $439.88, down $60 for the week.

As a result, the value of Apple-linked products suffered a one-week drop of more than 15%, said Craig McCann, founder of SLCG, in the Wall Street Journal story. “The vast majority of them are now underwater,” he says.

That means many investors will get far less than they expected. Losses exceed 25% on more than 100 of last year’s Apple-related products, SLCG estimates.

According to the WSJ, investors should have been asking one key question before making their purchase: Why would banks offer 10% interest when most one-year debt was paying about 1%?

The answer is this: Investment banks had something big to gain. The Apple-linked products gave them a cheap way of hedging or betting that Apple’s stock would fall. Now, in many cases, they can dump the fallen stock on conservative bond investors who might not want it and, in turn, will sell it again, the Wall Street Journal article says.

Case in point: The trigger yield optimization notes issued by UBS on Sept. 26. The face value of a note was set at $700.71, almost identical to Apple’s closing price three days prior. The one-year notes pay monthly interest at an 8.03% annual rate, or about eight times what the average short-term bond fund offered at the time, according to Morningstar. Investors bought $1 million of the notes, which had a 2% fee.

The notes are structured to repay the $700.71 at the time they mature this Sept. 26, with one exception. If Apple’s stock closes below $595.60 on Sept. 23, then investors don’t get their original principal back. Instead, they get one share of Apple. But Apple hasn’t closed above $595.60 since Oct. 31.

In other words, for investors to get all their money back, Apple shares must rise 35%. Right now, investors would lose at least 30%, even after counting the income they will earn, according to SLCG.

Making matters even worse is the fact that investors aren’t immediately told when their short-term bonds morph into Apple shares. Because the conversions aren’t trades, no confirmation is required to be given to investors. The majority of investors are unaware of their losses until their next account statement.

Says the WSJ story: “The implosion of these structured products is a reminder that there is no such thing as high yield at low risk. Complexity always favors the seller, not the buyer. And the house always wins.”