Myth #4: Structured product issuers pocket share dividends
Myth: Another common criticism structured notes get is that share dividends are unfairly kept from investors. If I invest in a structured note linked to a stock, I definitely want to receive it’s dividends! Perhaps structured notes are bad after all…or is it just another myth?
Reality: Let’s refer back to our product: the note is linked to the performance of Apple.
It pays a guaranteed income of 5% pa (regardless of Apple’s performance). At maturity (in one year), provided Apple has not fallen by over 40%, invested capital is paid back in full. If you were to invest in this product, you would indeed not receive a separate payment with Apple’s dividend (currently yielding around 0.5% pa).
Importantly though, this does not mean that investors are not receiving the economic benefits of dividends, in fact, they are.
In order to issue our Apple note, the issuer will need to buy shares of Apple. It will hence receive Apple’s dividends. While it does not pass on these dividends streams to the note holders, the product’s terms will already reflect the benefit afforded by the assumed dividends.
Upon the issuance of the note, the issuer will make an assumption of how much dividends it will get from holding the underlying stock during the lifetime of the product. Of course, past dividend history will be the biggest factor when making this assumption.
All else constant, the higher the dividend yield of a given underlying, the better terms of the product will have. So, if we were to build a similar note, but instead of Apple used another share that paid no dividends at all, we would obtain worse terms (in the form of lower coupon or less protection, for example).
In other words, while investors are not physically receiving Apple’s dividends, they are getting fairly compensated for it.
One might argue that there is no explicit obligation from the issuer’s perspective to include the assumed dividends when offering the product. It does not matter: competition ensures that issuers minimize their fees. As a matter of fact, given the competitiveness of the structured products market, issuers will often be very aggressive on their dividends assumptions, frequently leaving them exposed to substantial losses when dividends are cut. This was the case during the first semester of 2020 as some big banks will painfully remember.