The terms steepener notes, adjustable-rate market notes, spread-linked notes and structured notes all refer to structured investment products that present significant downside risk. However, over the past few years, these products have been aggressively marketed to investors looking to safely obtain a higher rate than offered by municipal bonds. Often, investors are disappointed to find out how the adjustable rate market operates and wonder why their investment advisor recommended such a risky product.
Financial Professionals May Be Exploiting Investors Who Are Looking for Better Rates
Over the past decade, interest rates in the United States have been at historic lows. Investment advisors and brokerage houses know that investors in a low-rate environment are desperate to lock in higher rates and create and market unique, niche products. Often, these products allow the possibility of higher returns but also carry significant downside risk to investors. This high-risk, high-return aspect of a financial product is not necessarily indicative of a problem if clients are adequately informed of the nature of the product. However, when financial professionals mislead investors by failing to disclose material risks, they violate the fiduciary duty owed to their clients.
What Is a Market Linked Note?
Steepener notes, adjustable-rate market notes, structured notes and spread-linked notes are complex financial instruments belonging to a category of products called structured investment products. The Securities and Exchange Commission defines a structured investment as “securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor’s investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows.” Essentially, the value of a structured product is highly correlated to the price of the underlying asset.
Adjustable-rate market linked notes can be tied to a variety of benchmarks or indexes, including stock indices (such as the S&P 500) or derivative benchmarks (such as the Constant Maturity Swap, or CMS). The steepener note pays interest according to how the underlying index or benchmark performs. The interest rate paid to investors ranges from zero (when the underlying asset performs poorly) up to a maximum percentage (when the underlying asset performs well). The details of how spread-linked notes perform, as well as how the note’s interest rate is calculated, are outlined in the note’s prospectus. However, these details are not well understood by most investors, who rely on their financial advisor’s assistance when determining which investments are a good fit for their portfolio.
The Current Interest Rate Climate Negatively Affects Many Steepener Notes
One of the most basic tenets of finance is the time value of money, which essentially means that access to money commands a premium. This premium is called interest. If someone wants to borrow money, they must pay the bank interest while they pay back the loan. It would seem to be common sense that the longer someone wants to borrow money, the higher the interest rate they must pay. And in times of increasing interest rates, this assumption remains true. However, when interest rates are decreasing, rates for long-term debt may be lower than those for short-term debt. This phenomenon is known as the inversion of the yield curve.
The yield curve measures the difference between long-term and short-term interest rates. When there is a consensus that future interest rates will be lower than they are today, experts say that the yield curve is inverted. An inverted yield curve is thought by most experts to be a precursor to a recession, during which interest rates typically remain low for an extended period of time.
Not only is an inverted yield curve a cautionary sign for the economy, but it has a negative impact on many adjustable-rate market notes. Fixed-income indices and derivative benchmarks typically perform poorly during times of low-interest rates. Because the interest rate paid by many spread-linked notes is based on the performance of these indices or benchmarks when the yield curve is inverted, many spread-linked notes will pay no interest to investors. In addition, low long-term interest rates mean that investors who put their money in a spread-linked note that is paying little to no interest forego the current opportunity to earn more interest on other short-term investments.
Investment professionals owe a fiduciary duty to their clients, requiring they provide sound investment advice. When a financial advisor or brokerage house fails to fulfill this duty, they may be liable to investors for their losses.
Factors Investment Advisors and Brokerage Houses Must Consider Before Recommending a Product
Every investor’s goal in purchasing a security is different. Financial advisors must listen to investors’ state goals and recommend only products that fit within those needs. Below is a list of a few considerations every investment advisor must consider when deciding which investment product to recommend:
- An investor’s time horizon and need for short-term liquidity
- The ability of an investor to hold the asset until maturity
- The Investor’s market outlook
- Potential tax implications of a specific investment type
- Whether an investor relies on income produced by their investments
In addition, each investment product presents its own unique set of risks. Regarding market linked notes, the following are material aspects of these products that must be disclosed and discussed with a client before an advisor can recommend the product:
- Liquidity Risk – Steepener notes are not publicly traded on any exchange and are generally considered illiquid instruments. This means that once an investor purchases a spread-linked note, they may not be able to exit the trade because there may be no buyers. If a buyer is found, the investor may receive significantly less than the amount they paid for the note.
- Credit Risk – Investors in spread linked notes bear the credit risk of the issuing institution. If the institution that issued a steepener note is unable to make payments when they are due, the investor has little to no recourse under the terms of the prospectus. Consequently, the creditworthiness of the institution may significantly affect the value of a market linked note.
- Lack of Interest or Periodic Payments – Many investors rely on interest or other periodic payments. However, if the payment of interest is variable and subject to adjustment based on the value of an underlying asset or benchmark, those factors must be disclosed and explained to the client in plain English.
- Call Risk – Many market-linked notes are callable, meaning that the issuing institution can call, or redeem, the note when it is advantageous for it to do so. When a note is called, there is no guarantee that the investor will be able to reinvest those funds at the same rate.
Without taking these factors into account, a financial advisor cannot ensure that a product is suitable for a client’s needs. When investment professionals recommend and sell products without fully considering the client’s stated goals or outlining the product’s potential risks, the investment advisor is breaching the fiduciary duty owed to the client.
Take the First Step Toward Recovering Your Losses by Contacting a Dedicated Securities Law Firm
If you purchased steepener notes, adjustable rate market notes, spread linked notes or structured notes, and have experienced either a loss of income and/or principal loss, you may be entitled to recover those losses from the financial professional who sold them to you.
The Wolper Law Firm represents investors nationwide in securities litigation and arbitration on a contingency fee basis. Matt Wolper, the Managing Principal of the Wolper Law Firm, is a trial lawyer who has handled hundreds of securities cases during his career involving a wide range of products, strategies and securities. Prior to representing investors, he was a partner with a national law firm, where he represented some of the largest banks and brokerage firms in the world in securities matters. To learn more and to schedule your free case evaluation, call 800.931.8452 or fill out the form below.