Structured income CDs appeal to yield-seekers, but tough fit for portfolios, adviser says

By Kenneth Lim

Boston, July 8 - Structured certificates of deposit that pay regular coupons and are linked to baskets of stocks may seem attractive to retail investors, but they can also be difficult to fit in a portfolio, an investment adviser said.

A number of structured CDs with that structure are currently being offered.

Harris NA is offering two series of contingent annual payout CDs linked to an equally weighted basket of common stocks.

The basket comprises the stocks of Costco Wholesale Corp., CVS Caremark Corp., Exxon Mobil

Corp., Home Depot, Inc., Honeywell International Inc., McDonald's Corp., Microsoft Corp., Monsanto Corp., Nokia Corp. and Wells Fargo & Co.

Interest is payable annually and will equal the sum of the weighted returns of the basket stocks. The coupon payment each year will be subject to a floor of zero, and each stock's return will be capped.

The five-year series has a return cap at 12% to 16%, while the six-year series has a return cap of 12% to 16% and a floor of negative 35% for each stock. The exact caps will be set at pricing.

JPMorgan Chase Bank, NA also has contingent coupon CDs due 2015 in the market linked to a basket of 10 equally weighted stocks.

The underlying stocks are American Express Co., Barrick Gold Corp., Boeing Co., Campbell Soup Co., Caterpillar Inc., ConocoPhillips, Goldcorp, Inc., Home Depot, Inc., 3M Co. and Time Warner Inc.

Interest is payable annually. For the first year, the coupon will be between 4% and 6%. After that, the coupon will be the sum of the weighted performances of the reference stocks, with a floor of 0.5%.

For each reference stock, the performance will be equal to the coupon cap if the stock closes above the return threshold of 10% to 15%. The exact amounts will be set at pricing. Otherwise, the performance will be equal to the stock return.

JPMorgan has a second series of CDs due 2014 linked to the same basket.

For the shorter CDs, annual interest will be the sum of the weighted performances of the reference stocks, with a floor of 0% and a cap of 11% to 15%. The exact caps will be set at pricing.

Yield seekers

The products offer investors a way to enjoy FDIC-insured principal protection on their investment while having a return that is pegged to another asset class that could have potentially better returns, the adviser said.

"From the investor's standpoint, you're getting potentially equity-like returns on the upside with none of the losses on the downside," the adviser said.

Investors are usually looking for alternatives to straight CDs, and those investors are probably not too concerned that the coupons are capped because the caps are usually much higher than current CD interest rates, the adviser added. But the caps should be an important factor in analyzing the products.

"The cap is very important because that's how the issuers are able to offer the product in the first place," the adviser said.

"I think if you look at most of the products, you'll see that when they're calculating the payout, there's a cap on the upside but no cap or a lower floor on the downside. What this means is that even though the cap is high, there's also a good chance of an underperformer in the basket dragging down the returns of the overall basket. One stock can only raise the average up by the cap divided by the number of stocks in the basket, but it can lower the average significantly more."

Stock picking products

The products have a strategy that is not too different from stockpicking, the adviser said.

"Most of the products I've seen so far, it looks like they're just picking 10 large-cap stocks in a number of sectors, but there's no real close correlation between them," the adviser said. "That's one way that brings down the cost of the product. That will bring down the volatility of the basket, but that's good for the issuer, not the investor because the lower the volatility, the lower your potential returns."

A product like this may not fit easily into a portfolio, the adviser added.

"If you show me a product like this, where does it count in my allocations?" the adviser said. "I could consider it cash because it's a CD, but my returns are not fixed. And because it's such a themeless basket of stocks it's not easy for me to come up with a coherent view on where the basket is going to be after five or six years. It's not like it's an index, which represents a market or a sector of the market and it's easier to come up with a view on that sector."

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