Investments in structured notes are growing worldwide making it one of the most popular financial securities. Structured notes provide unique tailored investment that provides the investor with specialized investment objectives, risk tolerance, and financial goals.
In this blog let us learn about the Benefits of Investing in Structured notes, how they work, their types, their advantages and disadvantages, and their comparison with traditional investments.
What Are Structured Notes?
Structured notes are hybrid financial securities that combine Swiss bonds and derivatives. The bonds are issued by financial institutions that protect the principal at the time of maturity. A portion of the amount is invested in derivatives such as a stock, index, commodity, basket of equities, or currency. The Investment in derivatives helps in generating higher returns while reducing the risk. The structured notes usually come with in-built protection and downside protection which safeguards the principal amount and the downside risk.
Investment in structured notes is a good option for a diversified portfolio and at the same time increases returns. The return on a structured note is dependent on the underlying asset. These notes are designed to meet specific investment objectives and financial goals for a variety of investor needs.
How Do Structured Notes Work?
Structured notes consist of a debt component and an embedded derivative component. The derivative component determines the returns and the payoff of the structured note based on the performance of the underlying asset, while the debt guarantees that the issuer will get the principal amount at maturity.
The investor of the structured note can customize the structured note to meet his investment objectives, risk appetite, and financial goal. The investors can also customize the payout structure based on their needs.
Types of Structured Notes
The different types of structured notes are listed below.
1. Principal-Protected Notes
Principal-protected notes are notes whose principal amount is guaranteed when the note matures. The principal amount is returned fully without considering the performance of the underlying asset as this note comes with a money-back guarantee. Structured notes with principal protection are suitable for risk-averse investors. Principal-protected notes may offer lower coupon payments compared to other structured notes.
2. Income Notes
Income notes are designed to provide regular income through coupon payments. The income notes are linked to various underlying assets. When the underlying asset performs well the investor receives higher coupon payments. The payout through coupon payment is done periodically. These notes provide high returns as they carry high risks.
3. Growth Notes
Growth notes are designed for capital appreciation. The investor can benefit from the stock or ETF appreciation. Growth notes can provide coupon payments based on the appreciation of underlying stocks and also provide downside protection.
4. Equity-Linked Notes:
Equity-linked notes are linked to specific equity or equity indices. The investors profit from stock market gains or the upside of the underlying stock while mitigating downside risk.
5. Structured Deposits:
Structured deposits have a zero coupon bond and a derivative component. The derivative component is usually an option. The zero coupon bond is issued at a lower rate compared to its value on the maturity date. The remaining amount is used to purchase the option of an underlying asset.
For example, let us say the zero coupon bond is bought at 80% of its maturity value. The rest of the investment 20% is invested in the option of the underlying asset. So 20% will be invested in the stock market in the call option if the stock market is bullish. When the stock market goes up the call option will capture the upside gains.
Advantages and Disadvantages of Structured Notes
Advantages of Structured Notes
Structured products have several benefits. Below are the benefits listed for in-depth understanding.
Customization and Flexibility
The structured note is flexible in setting the risk profile based on the investor’s need and the also the time frame for the investment. The structured note can be customized based on the risk appetite and investment objective of the investor. The investor can choose from a group of assets and the period can range from 6 months to 20 years. Customization is one of the biggest advantages of structured notes.
For example: if an investor has a high-risk appetite he can choose a yield enhancement note that has high risk and high returns and may not have full capital protection on the other hand, If an investor is looking for capital amount protection with moderate returns, he can choose principal-protected note, where the principal is protected at maturity and some amount is invested in the stock market for moderate returns.
Downside Protection
Many structured notes come with in-built principal protection and downside protection features. The initial investment is protected even if the underlying asset has underperformed. This downside risk protection can be appealing to investors in flat and poor market conditions.
For example: if the investor is looking for principal protection then the investor can choose principal-protected notes so that he can receive the principal investment back at maturity, regardless of the performance of the underlying asset. Thus limiting the losses.
Potential for Enhanced Returns
Structured notes give higher returns compared to traditional investment options. The structured notes earn returns based on the performance of the underlying asset. This enables the investor to benefit from the positive market changes. The in-built principal protection and downside protection act as a protective shield for the investment and there is a potential for higher returns.
For example, if a stock does well, a structured note linked to its performance will provide a significant return compared to conventional bonds or savings accounts.
Diversification
Structured notes help in a diversified investment portfolio. The underlying asset can be selected from a range of asset classes like stocks, indices, options, currencies, commodities, etc. This diversification feature helps to beat inflation and aims for higher returns. More than one underlying asset can be selected for structured notes, which mitigates the overall loss that could arise due to a single asset. Diversification is important for long-term investing success. Most of the investors look for diversification in their portfolio.
Customized Payout
Structured notes offer a variety of payout. The investor can choose from different payout options. The investor can select an income note or growth note based on his needs. Income notes offer fixed-income coupons like bonds. A growth note offers a fixed income coupon along with an upside income if the underlying stock does well.
Time Savings
Structured notes can save a lot of time for investors by creating a diversified and hedged portfolio which would otherwise involve a lot of time and effort if it had to be done individually. Structured notes can be created in one place and can involve many underlying assets.
Exposure
Structured notes can be tied to many underlying assets of different asset classes. This wide exposure can also give consistent income to the investor.
Known Maturity Dates
In any financial planning knowing the maturity date is the key. The investor can choose when he needs the structured notes to mature. Under certain conditions, if an auto call of the structured fund is done, that is if it matures early then reinvestment in structured notes could be more profitable.
Enable Complex Investment Strategies
The structured note can be created as a combination of stocks, options, currencies, commodities, and other financial instruments. One can invest in structured notes to get a combination of different financial instruments instead of investing in each one individually which will take a lot of time, effort, and investment expertise.
Disadvantages of Structured Notes
Structured notes come with certain risks and disadvantages. Below are the disadvantages.
Complexity
Structured notes are complicated assets to understand. The investment in derivatives makes it difficult for the investor to fully understand its complexities. The benefits and the risks of the structured note should be analyzed carefully. The investor needs to understand the payout structure impacted by the derivative component.
Credit Risk
A structured note is a debt security. The creditworthiness of the issuer should be analyzed before investing in structured notes as it is an unsecured debt for the financial institution. You should check the credit rating and financial status of the company before investing in structured notes. The investor is at risk if the issuer of the structured note defaults.
Liquidity Risk
The structured notes are illiquid. The investor needs to wait till maturity to get back the amount. The investor cannot sell the structured note in the open market. Some structured notes can be sold in the secondary market for a lower price or significant loss. It can get really hard to buy or sell your structured notes in the secondary market.
Market Risk
Structured notes consist of a derivative portion that is linked to the market. The market volatility is a risk that the investor has to take. Due to some bad luck if the market falls just before the coupon payment or the date of maturity, the investor may not get good returns. Though the market may recover after that.
Tax Considerations
Structured notes are seen as debt instruments and so they are taxed as ordinary gains which is higher than the tax on capital gains. Sometimes tax may have to be paid even before receiving the returns. The structured note should be checked for tax implications before investing.
Enhancing Portfolio Performance with Structured Notes
Adding Structured Notes to Your Portfolio
The addition of structured notes in the investment portfolio can help with diversification and risk management. Structured notes help to have a long-term successful investment portfolio due to its principal protection and downside protection. The combination of bonds and derivatives makes it a balanced portfolio. The bonds make the capital amount secure and the derivatives aid in achieving higher returns.
Managing Risk with Structured Notes
Structured products are exposed to market volatility. The downside protection of the structured notes manages risk and safeguards the amount invested in structured notes. Structured notes can be very appealing because of this feature.
Tailoring Investments to Specific Goals
The structured notes are tailored as per the investment objectives, risk-return profile, and financial goals. The financial goals can be growth, income generation, or capital preservation all of these can be met with structured notes.
Role of Financial Advisors in Structured Notes Investments
The structured notes are complex to understand. To make sure that the investment objectives and the financial goals are met it is best to take the advice of a financial advisor. Below are some of the roles of the financial advisor
Selecting the Right Structured Notes
The advice of the financial advisor is very important in selecting the right structured note. The financial advisor will select the right structured notes based on the investment objective, risk appetite, and financial goals of the investor.
Monitoring Performance of the Market
The market conditions of different derivatives are looked into by the financial advisor. Based on the market conditions and the investor’s investment objectives the financial advisor suggests the structured notes to the investor.
Structured Notes vs. Traditional Investments
Structured notes provide unique features compared to traditional investments like bonds, stocks, mutual funds, fixed deposits, exchange-traded funds(ETFs), and many more. Structured notes provide customized investment options such as risk management, higher returns, and diversification.
Comparison with Stocks
Investors in stocks become the shareholders of the company and are entitled dor the dividend and the capital growth. However, the investors in stocks are exposed to market volatility and risk.
Investors in structured notes get coupon payments and it is based on the underlying asset which could be stocks, bonds, currencies, commodities, etc. The underlying asset can also be a combination of stocks, bonds, currencies, commodities, etc which reduces the market risk in one particular asset. Structured notes have an in-built downside protection which protects the investor from market volatility. The investors in structured notes are not entitled to dividends.
Comparison with Bonds
Bonds are debt instruments by financial institutions. Bonds provide fixed interest at fixed interest rates. The principal payment will be done at maturity.
Structured note is a combination of bonds and derivatives. The bond provides principal protection at the time of maturity and derivatives provide higher returns. Structured notes also provide downside protection.
Structured notes provide higher returns compared to bonds.
Comparison with Mutual Funds
Mutual funds are pooled investments by many individuals investing in a diversified portfolio, which fund managers manage professionally. The individual investors are allocated units based on the amount of their investment. The net asset value of the units is based on the underlying stock’s performance.
Whenever the stock market is up the investor can gain from mutual funds by redeeming the units. Thus mutual funds offer diversification and expert management. The minimum amount is low and depends on the mutual fund. Mutual also offers a systematic investment plan (SIP).
Structured notes offer tailored investment solutions to achieve the investors’ objectives, risk-return profile, and financial goals. Structured note is a combination of bonds and derivatives. The minimum investment is $100,000 and there is no systematic investment plan (SIP).
Conclusion (Benefits of Investing in Structured Notes)
Structured notes are a hybrid security that is useful for investors who want to have a diversified portfolio, as they add different types of investments to your portfolio. Structured note allows you to invest in different asset classes like bonds, stocks, commodities, currencies, equity, etc. They can be customized as per the investor’s needs, risk-return profile, and investment objectives. It provides higher returns compared to traditional securities.
Structured notes might look like a good investment product, but they are complicated financial products. If you need to sell the structured note before maturity you may have to incur significant losses. They are hard to trade on the secondary market. It is always better to take advice from a financial advisor before investing in structured notes.
