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Beware Wall Street's Latest Dividend Gimmick

When investors want something, Wall Street never hesitates to give it to them. But the products Wall Street comes up with are often hard to understand and can end up burning you if you're not extremely careful.

Right now, millions of investors are doing everything they can to boost their income. With so many traditional income-producing investments having seen their payouts slow to a trickle, those investors have had to look well beyond their comfort zone to find ways to make up the difference in their personal budgets. Although regular-dividend-paying stocks have soared in popularity, Wall Street innovation has once again reared its head and come up with a way to squeeze even more income from certain stocks. But before you buy, you'd better understand the catch.

Dividends from Facebook?
As arguably the worst IPO in history, Facebook (Nasdaq: FB  ) shares don't have many fans right now. But As The Wall Street Journal reported over the weekend, Citigroup (NYSE: C  ) has managed to do what the fledgling social-media giant thus far hasn't: turn the company into a double-digit-percentage income-producing machine.

The secret is what's known in the industry as a structured note. For every $1,000 invested, Citigroup will pay the investor $42.50 per quarter in four equal payments. That comes out to a yield of 17% -- better than you'll get from nearly any dividend stock in the market.

But there's a trade-off. If on the date of any of those quarterly payments the shares have dropped 35% or more from the price on the day the notes were issued, then you lose the $1,000 you invested. Instead, you'll get about 51.7 Facebook shares per note -- the same number you'd have been able to buy on the issue date before any future price drop. Moreover, if that drop happens early in the note's existence, then you'll miss out on that quarter's payment, as well as the future quarterly payments you would have gotten.

But wait -- there's more!
Even if this deal sounds appealing to you, you won't be able to participate in the Facebook deal -- at least not right now. As the WSJ article, this arrangement was done with a relatively small $1.1 million investment, apparently for a rich Citi client. But a quick search of other structured products revealed several with similar attributes geared toward income-seeking investors:

  • A three-and-a-half-year "Buffered Digital Plus Security" on the Dow Jones Industrial Average (INDEX: ^DJI  ) that offers a total return of 27% to 32% if the Dow rises, but which pays nothing if the Dow drops and can result in a loss if the Dow drops by more than 10%.
  • One-year notes on Apple (Nasdaq: AAPL  ) that are similar to the Facebook securities, with interest of between 8% and 10% as long as Apple doesn't drop more than 20% from the date the notes are issued. If it does, then you'd be stuck with depreciated Apple shares.
  • Six-month securities tied to Cobalt International Energy (NYSE: CIE  ) , with monthly income at an annualized rate of 16% to 20% -- again with the potential to leave you with shares at a much lower value if the stock drops 30% or more in that six months.

If you're wondering what's in it for Citi, the answer is simple: All of these products come with selling concession fees ranging from 1.5% to 3%.

Worth the cost?
Obviously, you can't find interest rates like the ones these securities offer just anywhere. It would be possible to duplicate this strategy on your own by putting together a combination of stock and options positions, but in many cases you may well end up giving your broker more in commissions than the 1.5% to 3% concession amount Citi is asking.

With the short-term nature of all these products, though, the real danger is their speculative nature. Regardless of the fundamentals of the stocks and markets involved, anything can happen in such a short period of time. Rather than safe income investments, these are pure gambles on short-term market movements. While you might get lucky, you could just as easily get burned.

If you want to invest in Apple, you might prefer to do it the old-fashioned way: buying shares. But is that a good idea? Read the Motley Fool's premium report on Apple and get all the information you need to know about Apple's prospects right now, as well as a year's worth of free updates. Get your copy today.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.

Fool contributor Dan Caplinger finds Wall Street's inventions endlessly fascinating. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Citigroup, Facebook, and Apple. Motley Fool newsletter services have recommended buying shares of Apple and Facebook, as well as creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. There's no gimmick about the Fool's disclosure policy.

Read/Post Comments (3) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 04, 2012, at 10:46 AM, fool3090 wrote:

    Gambling for sure... and the house (brokerages) will always win. Not for me!

  • Report this Comment On September 04, 2012, at 11:59 AM, cloggervic wrote:

    It's just a variation on writing puts. If you write(sell) a put promising to buy the stock at the strike price if it falls below the strike price, you will receive a premium now.

    I just checked CIE puts. If you write a $20 strike put with expiry Jan 2013, you will receive $2.60 now. You will need to keep $20/share tied up in your account, but you can spend the $2.60.

    That's 13% in 4 months, or 52%/year.

    So these gimmicks are no deal at all; in fact you are being screwed and being asked to pay up front for it. At leat writing a put, the $20/share stays in your account and earns interest.

    Just write a put if this kind of thing is of interest.

  • Report this Comment On September 04, 2012, at 3:06 PM, TMFGalagan wrote:

    @cloggervic - Agreed that it's a variation on put-writing. The difference is that the person who buys the put you write has the option to exercise it at any time, forcing you to buy at potentially the worst possible moment, whereas the note only gives the issuer quarterly chances to exercise. That said, few written puts actually get assigned prior to expiration absent dividend considerations, so yeah, it's very similar indeed.


    dan (TMF Galagan)

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