In recent times Structured Notes have become a preferred source of investment for investors looking for customized investment solutions to meet their specific risk and return objectives.

The question however for both novice as well as experienced investors is whether these financial instruments are more expensive compared to traditional investment modes or rather are structured notes expensive.

This blog will help address this topic by looking at the cost components of structured notes, comparing the expense elements of these investments with other traditional investment vehicles, and evaluating if the benefits justify the cost linked to Structured Notes.

What Are Structured Notes/ Structured Products

Structured notes are hybrid financial products that incorporate a debt security which is a Swiss bond and a derivative component.

The investment in bonds safeguards the principal amount at maturity and the investment in derivatives helps the investor to take higher risks by investing in stock markets.

These notes provide returns dependent on the performance of an underlying asset, which could be an equities index, interest rate, or currency.

The derivative is intended to provide personalized exposure to specific market outcomes, making structured notes an appealing investment for those looking for customized risk and return profiles.

Structured notes diversify the risk by investing in different asset classes. The poor performance of a single underlying asset will not have a huge impact on the structured note. Though structured notes may look risky, they have built-in capital protection.

Structured notes may appeal to investors because of their potential for large yields, innovative payoff structures, and diversification.

However, the complexity and integrated derivative component may result in higher expenses than traditional investments such as equities, bonds, or mutual funds.

The minimum investment to buy a structured note is $100,000. The advice of a financial advisor can be taken before investing in structured products to reach the investment objectives and financial goals.

Cost Structure of Structured Notes

Structured notes are complex. Due to the complexity of structured notes and their multiple cost components, structured notes may appear expensive. The different types of costs involved are:

Issuance Costs

Issuance fees are charged by the issuer of the structured notes to include costs relating to issuing and creating a structured note. The structured notes are usually issued by banks and they include structuring costs, legal fees, and regulatory costs. These fees are added to the structured note.  

Management and Administrative Fees

Management fees are ongoing charges for administering and managing the structured note throughout its life. These fees cover administrative costs, monitoring expenses, and other management-related costs to ensure it operates as intended. Management fees generally are deducted from the returns which are generated by the notes.

Embedded Derivative Costs

The derivatives embedded in structured notes such as options, have costs related to volatility, time of maturity, and interest rates. All these costs are added in the structured notes, which increases the cost.

Tax Implications

A structured note is considered a debt instrument and the tax is charged at the ordinary income rate which is higher than the capital gains tax. Sometimes tax may have to be paid even before receiving returns on the structured note. Investors should consult financial advisors to understand the tax on structured notes before investing.

Liquidity Costs

Liquidity costs are the cost of buying or selling the structured note in a short period. Structured notes are generally less liquid than traditional stocks or bonds.  If you need to sell your structured note before the maturity date you may not get the full value and can incur a loss.

Distribution Fees

Distribution fees are incurred for marketing and selling structured notes to investors. These costs include commission and marketing fees which are paid to brokers and financial advisors who are involved in distributing the product. Distribution costs can vary depending on the distribution channel and the complexity of the structured note. The distribution cost is between 1 to 2 %.

What Are the Fees Associated with Structured Notes

Investors should be aware of fees associated with structured notes, as understanding these costs is critical for investors because they can considerably alter the net returns of the investment.

Product Fees: These are fees charged by the issuer to create the structured note. The fees relate to customization and initial costs.

Distribution fees: These fees are paid to financial advisors offering structured notes. Their fees can range from 1 – 2%.

Hedging fees: To reduce the risk arising due to the derivative component, issuers pay hedging fees, which are often passed on to investors.

Management fees: Some structured notes may include ongoing management fees, similar to mutual funds and exchange-traded funds (ETFs).

Structured Notes Compared to Other Investments. Are Structured Notes Expensive

Some differences appear when structured notes are compared to other traditional investments such as equities, bonds, mutual funds, and ETFs. Listed below are the differences

customize and complex: Structured notes provide specific diversified investments that could be complex to understand, while traditional investments do not provide customization and are simple to understand.

Cost Structure: Structured notes have higher fees due to the diversified derivative component and the complexity of creating the structured note. On the other hand, traditional financial instruments carry lower fees.

High Returns: Structured notes can yield higher returns compared to traditional financial instruments. However structured notes depend on the performance of the underlying asset and they also carry higher risks and costs.

Are There Hidden Costs in Structured Notes

Though most of the fees are known to the investor, the hidden costs should also be known to the investor before investing in structured notes. The investors should be aware of the hidden costs and analyze them before investing. Below are the hidden costs.

Liquidity Costs: If the investor wants to sell the structured note before its maturity, then the investor may have to bear a considerable amount of loss or may not be able to sell. Only some structured notes can be sold in the secondary market that too at a low rate compared to the purchase price.

Market Impact Fees: Due to market volatility of the derivative component hedging and modifying fees may be included. Some structured products may not be able to be modified.

How Does the Issuer Impact the Cost of Structured Notes

The cost of the structured note is largely influenced by the issuer. Below are the factors influencing the cost of the structured note based on the issuer.

Credit Rating: The creditworthiness of the financial institution is important so that you don’t lose the principal and the interest. The issuer of the structured note may charge a higher price if the credit rating is good. This can increase the price of the structured note.

Pricing Model: A structured note includes creating fees, issuing fees, and margin fees, which may increase the cost of the structured note.  

Market Conditions: The market conditions at the time of issuance will determine the fees on the structured note.

How Does the Market Environment Affect Structured Notes

The market environment has an impact on the pricing and performance of structured notes. The investor must consider the factors listed below before investing in structured notes.

Interest Rates: Changes in interest rates of the bonds can have an impact on the pricing of the debt security component.  The investor should look for reasonable interest rates to get a good return on their portfolio.

Market Volatility: At the time of issuance if there is high market volatility high hedging costs will be added to the structured note which results in higher costs for investors.

Economic Conditions: The overall economic conditions, such as inflation and growth forecasts have an impact on the derivatives. The performance of the derivative will determine the return on the structured note.

Why do Structured Notes Come at a High Cost?

Structured notes provide customized investment solutions based on the investor’s needs. But this customization comes at a high cost. Let us look into the various factors that influence the cost of structured notes.

Complexity and Expertise

Structured notes are customized as per the investor’s needs, risk appetite, and financial goals. The financial institution must hire special teams with experience in creating customized products. Since this involves the complexity and expertise of financial instruments it comes at a higher cost to the investors.

Time and Effort

Structured notes are a combination of bonds and derivatives. The derivatives can be stocks, commodities, currencies, equities, or a basket of stocks. Customizing a structured note based on the derivatives needs a lot of time and effort.

Financial advisors and structuring teams put a lot of effort into determining the needs of investors, creating suitable structures, and making sure that regulations are followed. Higher prices are due to the greater time and effort necessary for these customized services.

Higher Risk Management Costs

Structured notes usually have built-in protection and downside protection due to which hedging costs are incurred. This type of risk management cost increases the costs of the structured notes.

Limited Economies of Scale

Economies of scale occur when production costs are distributed over a large number of identical products. However, structured notes are customized notes and are one-of-a-kind. Financial institutions are unable to take advantage of the same cost savings. Lack of economies of scale results in higher costs.

Regulatory and Compliance Costs

The regulatory norms and comprehensive documentation are necessary for customizing structured notes. The structured notes should guarantee compliance with rules and regulations. Every customized product needs to be examined and authorized. This includes administrative and legal costs which increases the overall cost of the structured note.

Are Structured Notes Worth the Return on Investment?

Structured notes depend on the investor’s objectives and risk-return profile. Structured notes provide the advantages of customized investment and higher profits and the disadvantage is that they carry higher fees and are complex to understand.

Structured notes are great to be added to an investment portfolio. They provide tailored investment in multiple asset classes and risk-return profiles. However, the complexity and the cost structure should be carefully understood.

Investors should properly understand the structured note documentation and the fee structure. The investor should weigh the risk-return in structured notes and make informed decisions. They can take the help of a financial advisor to help them make informed decisions.

What Are the Advantages of Structured Notes?

Structured notes provide various benefits. Below are some of the advantages of structured notes.

Customized Exposure:  The investor can select the derivatives market in which they want to invest. It can be stocks, currencies, commodities, etc. The investor can select based on the investment goals and risk-return profile. The structured notes offer customized exposure to specific markets

Potential for High Returns: The derivative component provides higher returns depending on the performance of the underlying asset. The returns are higher than any other traditional investment.

Downside Protection:  Structured notes come with in-built downside protection which limits the downside losses. This helps the investor in safeguarding the initial investment and also reduces the risk considerably.

What Are the Disadvantages of Structured Notes?

Disadvantages of structured notes include:

High costs: Structured notes include various kinds of fees like issuance fees, legal fees, administrative fees, distribution fees, hedging fees, and so on. This increases the cost of the structured notes.

Complexity: The combination of Swiss bond and derivative components and the payout structure makes structured notes more complex and difficult to understand compared to other traditional investments.

Credit Risk: A structured note is a debt instrument. The creditworthiness of the financial institution issuing the bonds should be checked. If the issuer defaults, investors may lose their whole investment.

Lack of liquidity: If you want to sell your structured note before it matures you may have to sell it at an amount lesser than you have bought it. You may also not be able to sell structured notes. Only some structured notes can be sold in the secondary market.

Tax: Structured notes are taxed at ordinary income rates which are higher than capital gains. The tax may have to be paid even if the structured note has not reached maturity and the investor may have not got any cash from the structured note. The investor should go through the tax implications before investing in a structured note.

Key Takeaways

• Structured notes combine debt security and derivative components to provide customized exposure to specific markets.
• Structured note’s cost structure includes fees for structuring, distribution, and hedging.
• Structured notes have higher returns and also higher expenses and complexity than other traditional investments.
• Investors should be aware of hidden costs, such as liquidity and market impact fees.
• The issuer’s credit rating and pricing strategy have an impact on the cost of structured notes.
• Market conditions, such as interest rates and market volatility, influence the cost and performance of structured notes.
• The investor’s risk tolerance and financial goals influence whether structured notes are worth the investment.
• Investors considering investing in structured notes should analyze carefully and consult financial advisors to ensure they meet their investment objectives.

Understanding the cost structure of structured notes allows investors to make informed decisions to meet their financial objectives and risk tolerance. If you are thinking of buying a structured note, make sure to go through the costs and benefits of investing in structured notes. Also, take the advice of a financial advisor to meet your investment objectives and financial goals.