Understand the Risks & Benefits of Structured Notes
We have omitted a discussion of bonds
as you probably know about and understand that alternative.
The purpose of this site is to explain investments that pay
more than market rates. It is essential that you fully understand
these instruments before investing, as there is always a
trade off of these four items:
- Length of term
- Volatility
- Rate
- Credit risk (easily reduced or eliminated
by investing on high grade or guaranteed instruments).
Let’s take the example of a note
backed by GNMA, a federal agency. GNMA guarantees the loans that banks make so that
people can purchase homes. GNMA also loans money to banks in order for the banks to reloan that money for home purchases. To get the money it loans, Ginnie Mae sells notes to investors. If you invest in these notes,
your payments are guaranteed by Ginnie Mae. The annoying aspect of these notes is that you as the investor, get a payment each month consisting of interest and principal. Most investors only want their interest each month, not their principal returned.
To have these notes be more
suitable for various investors, a financial institution, say Merrill Lynch, might but the Ginnie Mae note and
split the note into two portions—the principal repayment
portion and the interest portion. You are able to buy one
portion or the other. It's important to understand that you no longer own the original note issued and guaranteed by Ginnie Mae. You now own and structured note, an obligation of Merrill Lynch.
Each portion of the structured note
is priced based on assumptions about interest rates and
the rate of mortgage prepayments.
Let’s say you buy
the portion where you receive the principal. As you know,
as people make their mortgage payments, part of each payment
is principal which you receive, as the investor. When interest
rates fall, people tend to refinance and you will get your
principal payments faster than expected. This increases
your yield (the faster you receive a stream of payments,
the higher your yield).
The opposite can also happen. Interest rates rise, and
the length of your investment (the time it takes to receive
your principal) stretches out. This reduces your yield
as money received in the future has a lower present value
today. These changes in yield cause the market value of
these securities to change dramatically. Changes in market
value are only important if you need to sell into the market.
These types of securities are great for people who love to
guess about the future because they can put their money where
their mouth is.
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