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Here's how structured notes work.

Structured notes were beloved by Wells Fargo bankers. The SEC warns that they are incredibly risky for the average investor. 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 is generally considered safe, the inclusion of stocks and derivatives can make them volatile.

What Are Structured Notes?

A structured note is a “hybrid security.” It combines the features of multiple different financial products into one. Structured notes combine bonds and additional investments to offer the features of both debt assets and investment assets.

Structured notes aren’t direct investments, but derivatives. They track the value of another product. The return on a structured note depends upon the issuer repaying the underlying bond and paying a premium based on the linked asset.

Let’s look at a couple of examples to see how that works in practice.

  • 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).
  • 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, the bond component is guaranteed. Some structured notes, but not all, include the entire principal in that bond.

Derivatives vs. Bonds

The derivative component could be linked to a single stock or an equity index. It could be based on the commodities market or foreign currency prices.

There is risk attached to both portions. The derivative offers only speculative profits. The bond is considered 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.

Benefits of a Structured Note

Here's how structured notes work.

A structured note is a way for retail investors to access parts of the market that they ordinarily might not see.

It 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 reputable institution and don’t receive such protection for your principal, that’s where risk (including bond default risk) enters the equation.

Risks of Structured Notes

The SEC list has eight separate warnings on its website related to structured notes. Here are just a few of the reasons to exercise caution with structured notes.

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 is based entirely on investment performance. Your principal may be in the balance as well.

A note linked to the Dow Jones 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 complicated 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 you’re somewhat stuck with it.

However, the bond issuer can include a call provision that recalls the structured note before maturity if it’s losing money. Your money is locked up 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

Here's how structured notes work.

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 considerable 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.

Investment Tips

  • If you’re uncertain about the risks behind a structured note, consider consulting a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Structured notes are risky, but bonds are often considered 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.

Photo credit: ©iStock.com/NicoElNino, ©iStock.com/AzmanL, ©iStock.com/Petar Chernaev

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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