What is a STRATS (Structured Asset-Backed Trust Security)?
A structured repackaged asset-backed security (STRATS) is a derivative that pays an income stream to the holder based on a trust’s interest in an asset-backed security (ABS) and related derivative. .
Key points to remember
- An asset-backed structured rollover (STRATS) is a securitized investment that bundles ABS with a derivative contract to produce income for investors.
- STRATS continue to pay income to holders as long as the value of the underlying ABS securities does not rise or fall beyond predefined thresholds.
- Although they can provide above-average income returns to investors, STRATS are complex and nuanced financial instruments that have been the subject of controversy.
Understanding Repackaged Asset-Backed Structured Fiduciary Securities (STRATS)
Asset-Backed Structured Trust Securities (STRATS) were developed by Wachovia Bank in 2005. Investors who buy STRATS technically buy shares of a trust, which pays investors income based on a combination of the interest of the trust in an equity security and a derivative product. The complexity of the name offers an indication of the complexity of the underlying product.
Structured products combine investments in traditional securities with a derivative component to generate a more personalized set of investment risks and returns than an investor would find by investing only in a traditional security. Investors who favor structured products generally have very specific needs that are not easily met by a more conventional financial instrument.
Refurbished products allow investment firms to resell existing assets or securities in a different form. In the case of STRATS, a trust repackages asset-backed securities (ABS), which consist of bonds or notes backed by an underlying asset that serves as collateral. The trust then combines these securities with a derivative, usually an interest rate swap used to hedge against interest rate risk in the securities component. The trust bases its payments to investors on the income streams from the two components.
Wells Fargo’s Controversial STRATS Problem
In 2012, the Financial Industry Regulatory Authority (FINRA) fined Wells Fargo Advisors for recommendations it made to investors regarding a series of floating rate STRATS that fell precipitously in value. The STRATS in question involved a combination of a preferred security issued by JPMorgan Chase and an interest rate swap to hedge the security’s exposure to rate changes.
Although the STRATS series prospectus contained a warning of substantial losses if JPMorgan early redeemed the stock, the bank reportedly marketed the product as a conservative investment. After Wells Fargo retained part of JPMorgan’s gain as compensation for the early cancellation of the interest rate swap, in which JPMorgan also served as counterparty, investors suffered a substantial loss on their shares.
While Wells Fargo insisted the product’s prospectus contained enough warnings for investors, FINRA determined that the company failed to educate its brokers about the risks inherent in the product. Some experts argued at the time that Wells Fargo should have made its risk warnings more prominent in its prospectus. To avoid such negative surprises, retail investors should always research investment products to ensure they understand all of their elements and read the prospectus carefully before committing to an investment.