Structured notes offer investors options that are otherwise unavailable, but there’s reason to be wary of them. While structured notes do contain a bond element that’s generally considered safe, the inclusion of stocks and derivatives can make them a bit more volatile. This hybrid nature makes them interesting investment opportunities, though. There are also a number of different types of structured notes.
If you have questions about including structured notes in your portfolio, consider working with a financial advisor.
What Are Structured Notes?
A structured note is a hybrid security. It combines the features of multiple different financial products into one. They combine bonds and additional investments to offer the features of both debt assets and investment assets. Structured notes aren’t direct investments, but rather they’re derivatives. This means they track the value of another product. The return on a structured note depends on the issuer repaying the underlying bond and paying a premium based on the linked asset.
Let’s break down some structured note examples to see how this works in practice:
Structured Note Examples
First, let’s say a bank issues a structured note with no interest rate. Instead, the note’s return is based on the performance of the S&P 500. By linking the return to the S&P 500 the bank has created a derivative. It has not directly invested in any related stocks. The note’s value derives from the value of the stock market. In one year the note matures and the S&P 500 has increased 10%. In this case, the bank would return the full principal (based on the bond component of the note) and would issue a 10% return (based on the derivative component of the note).
Now let’s say a bank issues a structured note with a 2% fixed interest rate and a 10-year maturity. The note also has an option for early redemption if 10-year Treasury bonds interest rates exceed 2.25%. In this case, the bank would return the full principal plus a 2% interest rate when the note matures (based on the bond component of the note). However, the holder could get money out of the note early if Treasury bonds become a better investment (based on the derivative component of the note).
In each case, there is a guarantee on the bond component. Some structured notes, but not all, include the entire principal in that bond. The derivative component of structured notes could be linked to a single stock or an equity index. They could also be based on the commodities market or foreign currency prices.
There is, however, the risk attached to both portions. The derivative offers only speculative profits. The bond, conversely, is a certainty, but the likelihood that an issuer will repay the bond hinges on their creditworthiness.
The institution may take a portion of the proceeds from selling the structured note and invest in a related index fund. That institution is then counting on the results of that investment to pay the derivative section of the note.
Types of Structured Notes
Just like much of the investment market, structured notes come in more than one version. With stocks, this variation comes from the sizes of companies. For instance, there are large-cap stocks, small-cap stocks and geo-specific stocks. With bonds, there are corporate bonds, municipal bonds, Treasury notes and more.
There’s a similar system within the structured note space, only they vary by return method. In other words, each type of structured note earns returns through different means. Here’s a breakdown of five main types:
Benefits of Structured Notes
A structured note is a way for retail investors to access parts of the market that they ordinarily might not see. This makes them inherently valuable to retail investors who don’t have tons of capital to invest.
For instance, structured notes can include a risky investment like gold futures, while providing the security of a bond. If that bond comes with a principal guarantee, the worst outcome is that your money effectively sits idle. If you don’t invest with a reputable institution and don’t receive such protection for your principal, that’s where risk (including bond default risk) enters the equation.
In concert with the above, structured notes allow investors to make unique bets on their market expectations. For example, you could build a structured note based on bull-put spreads that allows you to earn returns even if the market is stagnant. These bets, like all similar investments, come with heavy risk.
Risks of Structured Notes
Despite their unique ability to combine safety with returns, structured notes have plenty of risks. Here are four common reasons to exercise caution with structured notes in your portfolio:
Apparent Security
The bond component of a structured note can make this product seem more secure than it actually is. The bond portion of many structured notes might guarantee only a portion of your money back. It might also guarantee just a base return if the rest of the investment goes well.
Market Risk
The derivative portion of structured notes are exposed to the risk of whatever market they are tied to. Your return comes entirely from investment performance. Your principal may be in the balance as well.
A note linked to the Dow Jones Industrial Index or S&P 500 may seem stable. But all investment carries risk. Linking the note to more speculative or exotic products can magnify that risk significantly.
Complexity
A structured note can help average investors test new markets. But commodity futures and foreign currency bundles can be extremely complex for those average investors. It’s possible to lose a lot of money before you fully understand the risks and commitment behind a structured note.
Liquidity and Call Provisions
Your money is locked up in a structured note until the bond matures. There isn’t a market to resell a structured note to, so it’s basically yours.
However, the bond issuer can include a call provision that recalls the structured note before maturity if it’s losing money. You can then lose your money if the derivative portion performs poorly. If that derivative performs well, the issuer can recall the note before you are able to collect a return.
Bottom Line
A structured note can open up myriad opportunities for investors. A disreputable institution or a wary bond issuer can slam all of them shut. Be aware of the significant risks before considering this particular investment.
If you feel your portfolio can withstand the risk for the potential rewards that structured notes can provide, they may be worth considering. However, if you’re approaching structured notes with any trepidation, consider seeking some impartial advice.
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