What Are Structured Notes and How Do They Work?

Structured notes offer investors access to 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 note itself can carry substantial credit, market and liquidity risk. Additionally, some structured notes can expose investors to a loss of principal. Still, the hybrid nature of structured notes can make them interesting investment opportunities to some.

A financial advisor can help you determine whether structured notes fit into your investment portfolio strategy.

What Are Structured Notes?

A structured note is a hybrid security that blends the features of multiple different financial products. It combines bonds alongside additional investments to offer the features of both debt assets and investment assets.

Structured notes aren’t direct investments but rather 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.

There is risk attached to both portions of a structured note. The derivative component creates a payoff dependent on the reference asset or benchmark, while the debt obligation exposes the investor to the issuer’s credit risk.

Structured Notes Examples

Let’s break down some structured note examples to see how they work in practice:

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. Rather, the note’s value derives from the value of the stock market.

Let’s say in one year, the note matures and the S&P 500 has increased 10%. If the note’s terms provide 100% principal protection at maturity and 100% participation in the S&P 500’s 10% gain, with no return cap or other adjustment, the bank would return the principal and pay a 10% return. The actual payout, however, depends on the note’s specific formula. It also remains subject to the issuer’s ability to pay.

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 a call provision that allows the issuer to redeem it early under specified conditions, such as when an interest-rate benchmark reaches a particular level. In that case, the investor could receive the amount specified by the contract before the original maturity date.

Not every structured note guarantees repayment of principal, though. Some offer full principal protection at maturity. Meanwhile, others protect only part of the principal, while some provide contingent or no principal protection. Any promised payment also depends on the issuer’s creditworthiness. The derivative component of structured notes could be linked to a single stock or an equity index. It could also be based on the commodities market or foreign currency prices.

Types of Structured Notes

Just like much of the investment market, structured notes come in more than one variety. Each type of structured note earns returns through different means. Here’s a breakdown of the five main types:

Equity-linked structured notes: These structured notes earn returns based on the performance of stocks. They can follow both individual stocks or groups of them.
Commodity-linked structured notes: Structured notes in this category follow commodities or commodity indexes. Examples include metals, livestock, agriculture and energy.
Currency-linked structured notes: These structured notes follow the ebbs and flows of currencies like the Canadian dollar or Euro.
Interest rate-linked structured notes: With these structured notes, returns depend on the levels of a specific interest rate.
Credit-linked structured notes: These structured notes follow specific credit risks or credit events of organizations like companies.

Benefits of Structured Notes

A structured note is a way for retail investors to access parts of the market they ordinarily might not see. This can make them valuable to those who don’t have tons of capital to invest. For example, structured notes may include a risky investment like gold futures while providing some downside protection if the particular note’s terms include it.

However, even full principal protection at maturity is dependent on the issuer’s creditworthiness, and it may not protect an investor who sells early. A principal-protected note could also produce little or no investment return during its term. 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.

Still, structured notes do allow investors to make unique bets on their market expectations. For example, you could build a structured note based on bull-put spreads that allow you to earn returns even if the market is stagnant. These bets, like all similar investments, come with heavy risk, though.

Risks of Structured Notes

Despite their unique ability to combine different payoff structures and market exposures, structured notes have plenty of risks. Four of the main ones include:

Apparent security: The bond component of a structured note can make this product seem more secure than it is. In reality, 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. Any principal protection generally applies only according to the terms of the note, often at maturity, and depends on the issuer’s creditworthiness. Structured notes are securities, rather than bank deposits, and generally are not FDIC-insured.
Market risk: The derivative portion of structured notes is exposed to the risk of whatever market they are tied to. Your return comes in part or entirely from the payoff formula tied to that market or benchmark. 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 risks. 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. However, commodity futures and foreign currency bundles can be extremely complex for 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: Structured notes often have limited or no active secondary market. If you need to sell before maturity, you may be unable to find a buyer or may receive substantially less than your initial investment. Some notes also include call provisions that allow the issuer to redeem the note early under specified conditions. An early call can limit potential future gains and create reinvestment risk if comparable investments are unavailable.

What Happens to Structured Notes At and Before Maturity

Structured notes are designed to be held until maturity, and the outcome depends on how the linked asset performs over the life of the note. At maturity, investors typically receive a payout based on the note’s specific terms, which may include full principal return, partial protection or performance-based gains tied to an index, stock, interest rate or other benchmark. If the conditions for a positive return are not met, the payout may be limited or reduced. In some structures, investors can lose some or all of their principal even if they hold the note to maturity.

Before maturity, structured notes generally offer limited flexibility. Unlike stocks or mutual funds, they usually do not trade on an active secondary market. This means selling early can be difficult or costly. Some issuers may offer to repurchase the note, but the price may be lower than the original investment and may reflect current market conditions, issuer credit risk and remaining time to maturity.

Call features can also affect outcomes. Many structured notes give the issuer the right to redeem the note early if certain conditions are met. If this happens, investors may receive their principal back along with a predefined return, or another payment specified by the note’s terms. However, they miss out on additional gains they may have expected over the full term of the note.

How Structured Notes Are Taxed

The federal tax treatment of a structured note depends on its specific terms and can be complex. Different tax treatment may apply to different notes, as there is no single tax rule that applies to every structured note.

Some structured notes can generate taxable income before the investor receives cash. For example, certain principal-protected notes may require an investor to recognize imputed interest during the term of the investment. Other structures can have different rules for interest, gains and losses.

The offering documents should describe the issuer’s expected federal tax treatment. Investors considering a structured note can review those disclosures with a tax professional before purchasing. This can be particularly helpful, given that the timing and character of taxable income may differ from those of a conventional stock or bond investment.

Bottom Line

Happy man looking over his investment portfolio.

A structured note can open up myriad opportunities for investors. However, the return and safety of the investment depend heavily on the note’s terms and the issuer’s ability to meet its obligations. Principal protection, when available, does not eliminate issuer credit risk, liquidity risk or the possibility of receiving little or no return. Be aware of the significant risks before considering this particular investment.

Investment Tips

A financial advisor could answer questions about risks behind a structured note. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Structured notes are risky, but bonds are often far safer. SmartAsset’s asset allocation calculator can help determine your risk tolerance and suggest an investment that’s right for you. Meanwhile, SmartAsset’s guide to buying bonds can offer a preview of that market for the risk-averse.