What Are Structured Notes?

January 3, 2023

What Are Structured Notes?

Structured notes are a type of financial instrument that combines a debt obligation — like a bond — with the potential for additional positive returns through the use of derivatives.

Derivatives refer to financial contracts whose value is linked to an underlying asset or group of assets, also known as a benchmark.

Sometimes called structured products, structured notes are a hybrid security that uses derivatives to adjust a bond’s risk-return profile. They’re typically issued by banks and other financial institutions and are often marketed to retail investors as a way to potentially earn higher returns than traditional fixed-income investments while also offering some degree of principal protection.

Structured notes can be complex and involve a variety of underlying assets and strategies, such as options, futures and other derivatives.

The terms of a structured product can vary widely, including the length of the investment, the level of principal protection, the amount of any potential return, and the level of risk. Terms are generally subject to the creditworthiness of the issuer.

Structured notes are a type of financial instrument that combines elements of both debt and derivatives. They are often issued by investment banks and sold to investors through broker-dealers.

How Do Structured Notes Work?

All structured notes combine two underlying pieces: a bond component and a derivative component.

  • The bond portion of the note takes up most of the investment and provides principal protection
  • The derivative portion is used to provide exposure to any asset class

Returns on a structured product are linked to the performance of an underlying asset, group of assets or index.

Understanding Terms of Structured Notes

Issuance: A financial institution, such as a bank or investment firm, will issue structured notes to investors. These notes are typically sold through intermediaries, such as brokerages or financial advisors.

Underlying asset: A structured note is linked to an underlying asset, which can be any asset class, such as stocks, bonds, commodities or currencies. The underlying asset’s performance will determine the value of the structured note.

Derivatives: Derivatives are financial instruments that get their value from an underlying asset. In structured notes, derivatives are used to create customized investment outcomes for investors. For example, the issuer may use options or futures contracts to create a structured note that pays out a fixed amount if the underlying asset performs a certain way.

Investment outcomes: Structured notes offer investors specific investment outcomes based on the underlying asset’s performance and the terms of the derivatives used in the structured note. These outcomes may include fixed returns, principal protection or participation in the underlying asset’s performance.

Risk and return: Structured notes can offer investors a range of risk and return profiles depending on the underlying asset and the terms of the derivatives used in the structured note. Some structured notes may offer principal protection and lower returns, while others may offer higher returns but with more risk.

Maturity: Structured notes typically have a set maturity date, at which point the investment will either be paid out or redeemed by the issuer.

Types of Structured Notes

There are a variety of different types of structured notes depending on investment objectives. For example, different notes can have different maturities, different call features, payoff structures, tax implications and creditworthiness of the issuers.

Here are some examples of different types of structured notes:

  1. Principal Protected Notes: PPNs are designed to offer principal protection to investors. This means that the investor’s full principal is typically returned at the end of the note’s term, regardless of the performance of the underlying asset.
  2. Reverse Convertible Notes: RCNs offer the investor a fixed coupon payment, while the value of the note is linked to its reference asset.
  3. Enhanced Participation or Leveraged Notes: EPNs offer investors the potential for higher returns through the use of leverage. Leverage is the use of borrowed money to increase the potential return on investment. These notes typically are linked to 2x or 3x the return on the underlying asset.
  4. Hybrid Notes: These notes combine elements of both debt and equity. They may offer the investor a fixed coupon payment, but also give the investor the potential for capital appreciation through the ownership of equity in the issuer.
  5. Credit-Linked Notes: These products are linked to the credit risk of a specific issuer or a group of issuers, such as a bond index. Credit-linked notes can offer investors a way to gain exposure to credit risk without owning the underlying bonds.
  6. Equity-Linked Notes: These securities are linked to the performance of a specific equity or a group of equities, such as a stock index. Equity-linked notes can offer investors a way to gain exposure to the stock market without directly owning stocks.
  7. Currency-Linked Notes: These notes are linked to the performance of a specific currency or a basket of currencies. Currency-linked notes can offer investors a way to gain exposure to currency exchange rates without directly owning a foreign currency.

Who Typically Invests in Structured Notes?

While structured products are marketed to both retail and institutional investors (such as hedge funds or pensions) they are more complex than many traditional investments for retail investors.

Investors in structured notes include those who are seeking customized investment products that are tailored to their specific investment goals and risk tolerances.

Structured notes can offer a range of risk and return profiles, so they may be appealing to investors who are looking for fixed-income investments with some level of risk management, or those who are seeking higher returns with more risk.

5 Benefits of Structured Notes

Structured notes can offer increased or decreased upside potential, downside risk and overall volatility.

  1. Customization: Structured notes offer investors the ability to customize their investment outcomes based on their specific investment goals and risk tolerances.
  2. Principal protection: Some structured products offer principal protection, which means that the investor’s principal investment is guaranteed to be returned, regardless of the performance of the underlying asset.
  3. Fixed-income investments: Structured notes can offer investors a fixed-income investment with some level of risk management, which may be appealing to those who are seeking a more stable investment.
  4. Potential for higher returns: Depending on the underlying asset and the terms of the derivatives used in the structured products, investors may be able to achieve higher returns than they would with traditional fixed-income investments.
  5. Additional exposure: Because of structured notes customization abilities, they can provide exposure to markets not generally found in traditional securities. For example, a structured note can depend on stock market volatility, as measured by the VIX.

Risks of Structured Notes

The basic premise of a structured note is something appealing to all investors — upside potential with downside protection, or protection against the loss of principal — but there are some tradeoffs when it comes to structured products.

Complexity: Structured notes can be complex financial instruments, which may make them difficult for some investors to understand. Especially as exposure to more complex or alternative assets has become more accessible through mutual funds, ETFs and fractionalized shares, sometimes this exposure is unnecessary.

Potential Loss of Principal: Structured notes may involve significant risk, and investors may lose some or all of their invested capital.

Lack of Regulation: Structured notes may not be regulated by financial oversight agencies in the same way as traditional investments, which could expose investors to additional risk.

Limited Liquidity: Structured notes may have limited liquidity, meaning that investors may have difficulty selling their investment before the maturity date. The flexibility of structured notes makes it difficult for large markets to develop for particular notes. that makes it difficult to trade one on a secondary market.

Buffer ETFs are a more liquid alternative to structured products, for investors looking to limit losses in exchange for smaller potential gains.

Fees: Structured notes may have higher fees than traditional investments, which could impact the overall return on the investment.

Market Risk: Market risk is present in all investments. Some structured products have principal protection, meaning the investor can’t lose the original investment. For structured products without it, investors can lose some or even all of the principal.

This risk is amplified when the underlying derivative, such as equity, interest rates, commodities or foreign exchange rates, is more volatile.

Credit Risk: Before investing in a structured product, it is important to consider the creditworthiness of the issuer.

While it may be tempting to hold the note until maturity, it is important to remember that you bear the risk of the issuing investment bank potentially defaulting on its obligation. This can lead to the underlying derivatives having a positive return while the structured product itself becomes worthless, as was the case for investors during the collapse of Lehman Brothers in 2008.

It’s crucial to recognize that a structured note adds an additional layer of credit risk to the market risk already present in any investment. Don’t be lulled into a false sense of security simply because the bank has a well-known name; credit risk can still exist.

The Bottom Line

Structured notes are a type of financial instrument that combines elements of both debt and equity.

They offer investors the opportunity to receive a fixed or variable return on their investment, while also providing some level of protection against market downturns through the use of embedded derivatives.

However, structured notes also carry a number of risks, including the risk of default on the underlying debt, the risk of the issuer’s creditworthiness, and the risk of loss due to market movements.

Given these risks, structured products may not be suitable for all investors. They may be a good fit for those who are looking for a potentially higher return on their investment and are willing to accept the risks involved. Additionally, they may be suitable for those who are seeking portfolio diversification and potentially mitigate market volatility.

Each offering is different, and financial advisors and the Securities and Exchange Commission (SEC) recommend investors to carefully read the prospectus to fully understand terms of the note and its implications.

This material is provided for educational purposes only. It is not investment advice and should not be the basis of an investment decision.

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