Let us move on to discover the blog titled ‘How do structured notes make money.’ This is in terms of the varied devices and mechanisms they apply to help investment portfolios grow. We shall also discuss the factors that impact the value of investments with respect to structured notes. Read on!
Introduction
To know how investments make money, you must understand how their working mechanism pans out for the investors. Only when you have a working knowledge of an investment plan can you decipher how much returns the portfolio may garner at the end of the maturity term.
Say, for instance, when you want to dabble with equity options, you must have a fair knowledge of how share values go up or down across bearish or bullish market trends.
Similarly, when you would like to know how bonds or fixed-income mortgage options work, you must analyze the underlying mechanism behind the same.
Structured notes are hybrid investment components that combine debt with equity. Therefore, you must analyze how the notes perform under simulated market conditions.
In a nutshell, only when you gauge the overall working mechanism of a financial product would you be able to analyze whether that product will make sufficient returns on your investment portfolio or not.
On this parlance, let us discuss how do structured notes make money while this is done on a detailed or comprehensive note. Shall we get started on the same?
What are structured notes- Meaning and conceptualization explained
Structured notes are hybrid investment components that comprise debt and equity. The debt component is a fixed one comprising bonds or fixed-income annuities. The debt usually protects the capital investment for investors on a contingent level. Although capital losses might be inevitable in case of adverse market conditions.
The other component of a structured note is an equity-related derivative component. The derivative component is also linked to notes and this is a variable component.
The equity derivatives comprise assets and we call them asset-underliers as these assets underlie within the structural outlay of the note. The asset allocation comprises stocks, a basket of high-paying securities, and currencies, to name a few.
While the bond helps mitigate losses and caps gains for investors, the upside returns on investment are linked to the performance of underlying assets that the notes are linked with.
How do structured notes make money- the underlying mechanism explained
Structured notes may garner returns for investors by deploying different types of payout mechanisms. This is because different types of assets can be linked to the notes.
Let us have a deep dive into what these mechanisms are and how they help notes garner better rates of returns for investors. Helping you get started here:
- Fixed Interest payments
If the terms of the notes comprise fixed interest payments, then the product issuers help investors get fixed interest payments on their notes. The payments can be periodic like say once every 3 months/ 6 months or 12 months. The interest payments are paid out in a similar way as in the case of bonds or fixed-income securities.
- Variable interest payouts
Variable interest payouts are coupon payments, and structured notes pay to investors. However, the interest payments in terms of accrued coupons on products like say autocallable notes.
Autocallable notes are structured notes wherein the underlying assets can be shares, stocks, or currencies. These notes have an in-built autocall facility that is further embedded in these notes.
The performance of underlying assets is gauged by product issuing firms on periodic quarters. We call it observation dates. There are pre-set conditions that need to be fulfilled for autocall triggers to be successful.
Once the assets reach their set conditions, the notes are auto-called and redeemed instantly. Here, the investor gets his principal amount camouflaged with variable interest payouts in the form of coupons.
These coupons are variable payouts as their values are determined by the performance of assets the autocallable notes are usually linked to.
- Potential payouts from equity markets
You have structured notes called Equity Linked Notes or ELNs. These notes are primarily linked to equity-based assets. The equity assets can take the form of shares, stocks, currencies, options, and futures.
The ELNs can either be designed as principal-protected ELNs or non-principal-protected ELNs.
Although the notes primarily try to protect investors’ capital investment, the market fluctuations or volatilities of equity markets may allow these notes to scrape out the investor’s cap by a partial or even complete amount. The potential payouts from equity notes depend on the performance of underlying assets in the equity market.
Under favorable market conditions, investors can earn more lucrative yields from ELNs as compared to traditional bonds or fixed-income securities. Dividends are also paid out to equity-linked assets for investors.
ELNs are also called growth notes as the growth indexes of equities have a favorable impact on the overall value of the investment portfolio.
- Commodities or currencies
The notes can be linked to highly lucrative commodities like gold. You call the notes Gold-linked notes or GLNs. Or, you can link your notes to high-paying currencies like US Dollars or Euros.
This way, you can aim for short-tenor investing options ranging from 6-12 months so that you allow the currencies or commodities to grow.
Once preset barriers are achieved on commodities or currencies you get interest payouts and the principal amount redeemed.
These are notes that are meant for investors who have immediate financial requirements to take care of.
In a worst-case scenario, the currencies or gold stay in your active trading account and you can keep watching the overall market movements to liquidate them into cash holdings or bank transfer settlements.
- Conversion of investments into equity shares
Structured notes can allow you to convert your investment value into underlying shares of a said company.
These are Reverse Convertible Notes or RCNs. In case the notes garner returns if preset conditions are met or fulfilled, investors are eligible to receive their principal amounts and interest earnings thereon.
On the contrary, if the performance of equity-based underliers does not perform as expected, the capital investment money is converted into underlying shares of the said firm. The number of shares gets computed through a compounding formula as designed by the product issuer firm.
In this case, investors can sell these shares under favorable market conditions to enhance their cash holdings to a considerable extent.
- Leveraged returns
You can add leveraging or turbo elements to structured notes so that they provide 2X or 3X returns on the investments as compared to regular non-leveraged notes.
Investors must be highly dynamic and not be risk-averse while they take into leveraged options in structured notes.
The product issuers may add turbo elements to enhance returns of investments if the underlying assets perform well in the market.
On the contrary, if the leveraged investments do not meet the expected standards, the portfolio can earn 2X or 3X level of losses too.
The turbo or leverage investment options are meant for those investors who want to see a potential hike in investment values over short tenor periods.
- Income notes
Knock-out notes are perfect examples of income notes as they allow the notes garner better yields over regular investment options. However, the knock-out values or preset conditions on performing or underlying assets must be fulfilled.
The notes garner lucrative returns in terms of higher coupons, dividend disbursements, or attractive interest payouts. However in case of noncompliance of assets to achieve knock-out levels, then the investors may lose a partial or complete value of their initial investment money.
These are income notes as you get income from different sources of the market and help you close deals at short tenor periods too.
- Principal Protection Notes or PPNs
For risk-averse or traditional investors, the underlying norm for them is capital conservation or capital preservation. Structured notes do not disappoint investors on this front as well. You have principal-protected notes or PPNs that help investors earn their capital investment money at the time the notes mature.
The investors receive their principal irrespective of adverse market conditions with respect to performing assets or linked-in assets of these notes.
Therefore, PPNs are perfect investment options for pensioners or retirees who save their lifetime savings and expect modest returns on their investment portfolios.
How do market conditions impact the performance of structured notes?
There are significantly visible market conditions that can impact the performance of structured notes in terms of the returns they earn in the market.
Let us have a run-down into what these factors are:
- Know-how on bearish and bullish market trends
Bullish market scenarios relate to rising markets. This is a market trend that is optimistic wherein you expect that the value of shares, securities, or commodities will rise in the future.
On the other hand, bearish market conditions refer to falling market conditions. Investment analysts or financial prodigy exponents predict that prices of shares or securities may fall in the future.
As structured notes have equity elements embedded in their structures, they have income levels that are linked to the performance of the underlying assets in the equity markets.
You must also have an understanding on how call option or put option are embedded into notes.
Therefore, it is always better that investors know how equity markets work so that they can predict how the value of their investments may appreciate or drop in the future.
- Interest rates
Changes in interest rates can impact the value of investments with respect to structured notes. Rising or falling interest rates can be a detrimental factor that impacts the returns of investments with respect to notes.
Interest-income ratios can be gauged by investors so that they can hedge between better interest-paying investment options as compared to poorly paying investment options.
- Inflationary norms
Growing inflation can cause the investment portfolios not to realize their complete potential and this can impact the overall growth portfolio of structured notes too.
When the purchasing power of people reduces due to inflationary concerns, then the return on investments in products may also not help you achieve your financial goals effectively and make you fall short of standards.
You must get advice from a financial advisor as to how you can keep your investment portfolios intact despite growing inflation in the economy.
- Market trends that apply
Market trends or socio-economic conditions can appreciate the value of investments considerably also causing a detrimental fall in the value of investment portfolios for investors on the whole.
Say, for instance, a global recession was announced in the US during the year 2008 wherein Lehman Brothers, a big investment company signed up for its bankruptcy.
In this period, several structured notes that were issued by Lehman Brothers stood valueless and these amounts were lifetime savings for retirees or pensioners and the money was wiped off their trays straight away.
Therefore, market conditions or trends can be favorable or turn out to be economic downturn scenarios. And these trends significantly impact the value of financial investment portfolios and structured notes are no exception to this.
- Tax implications
Tax implications can also impact the value of investments adversely. If the incomes you earn from growth or income notes are treated as regular sources of income, then most of your earnings will be deducted in the form of taxes and your returns on the investment may not hold that much of a value.
On the contrary, when you have the returns of investments treated as ‘capital gains’ income’ then lower slabs of taxation would be applied on the same.
The terms and conditions of structured notes differ from product to product. Therefore, it is always advisable to consult a tax advisor or a consultant to look for tax-saving havens to further build your investment portfolios.
The Bottom Line
Although structured notes are dynamic investment options that provide different channels of income to investors, these are also subject to a fleet of risks involved.
The notes have a whole lot of market risks, credit risks, and liquidity risks to name a few. You must therefore go through the investment disclosure documents thoroughly before signing in on the dotted lines.
You can also approach an investment or a wealth management firm to help you pick the correct investment options after evaluating the pros and cons of every type of structured product.
Frequently Asked Questions- FAQs
Q1. Is it safe to invest in structured notes?
Answer: A structured note is a type of investment with a bond component and equity-related derivative option. While the bond is a fixed component that provides contingent protection against capital, the return on a structured note depends on the performance of the underlying assets the note is linked with.
Q2. Are structured notes principal protected?
Answer: No, not all notes provide entire principal protection. While the debt comprises a bond portion, the derivative portion comprises asset classes that are volatile in nature. The note may provide contingent buffer against cap losses while it provides upside potential to investors.
Q3. Is structured note a lucrative investment and provides principal protection?
Answer: This is a debt security that is not entirely risky nor risk-free. Certain notes like PPNs or principal protected ELNs protect investing capital despite the performance of underlying assets in the stock market. Therefore, a structured note is a hybrid security that combines debt and equity on an optimal note.
Q4. Who usually issues structured notes?
Answer: The notes are usually issued by privately owned financial institutions or independant wealth maangers to sophisticated investors in the primary market. However, these notes can also be issued to middle-class retail segments in the secondary market at an affordable price-range.
Q5. What happens to the bond component and the rest of the investment in case of a default risk?
Answer: If the note issuer signs up for liquidity before maturity date then the investors may lose a portion of or entire value of the investment. This is what is meant by a default risk on structured notes.
