Risky derivatives still hurting investors

The siren song of high-yield securities is tough to ignore.

By Kim Peterson Oct 4, 2010 3:00PM
Blindfold © PhotoAlto / Jupiter ImagesInvestors are desperate for higher yields, and some are getting burned by plunging into derivatives they may know nothing about.

Take the case of Leona Miller, 84, a retired beautician interviewed by Bloomberg. Her Wachovia broker encouraged her to buy securities paying 9% interest, so she went in for $20,000. Within six months, Zeke Faux writes, her investment had lost 30% and the bonds were converted to shares of Merck (MRK).

How could that happen? Don't ask Miller, who admits she still doesn't understand it. What Miller bought would make anyone's head spin: a reverse-convertible note with a knock-in put option tied to Merck stock.

She bought a bond combined with a derivative, Bloomberg reported. The put option is what did Miller's investment in. When Merck shares got low enough, the option triggered, and Miller's investment was converted into stock.

For Miller, it was a painful introduction to the world of customized derivatives, complicated securities that certainly played a part in the financial meltdown over the past few years.

Despite their notoriety, customized derivatives can still be sold to mainstream investors as long as they're bundled with bonds into structured notes, Faux writes.

And banks are loving it because they get nice fees for selling them. Morgan Stanley (MS) charged a 3.5% fee on Leveraged CMS Curve, which looks great on paper for the first few years but then gets complicated. How complicated? Check out the prospectus.

One expert told Bloomberg that individual investors are simply incapable of valuing structured notes and their underlying derivatives.

So what can investors do to avoid getting burned?
  • Remember the if-it's-too-good-to-be-true rule.
  • Accept that we're stuck with low yields for a while. Until the Federal Reserve raises interest rates, lower yields are a reality even for the most astute investor.
  • Double-check your broker. Accept the advice and recommendations, for sure, but check them out elsewhere before plunging in.
  • Research everything. Read all the small print in the prospectus. Learn the terminology. No one else will do this for you.
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