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What Are Structured Notes In Investing And How Do They Work?

What Are Structured Notes In Investing And How Do They Work?

Previously only open to wealthier investors, structured notes play an active role in portfolios by shielding against market uncertainty, while providing upside return opportunities.

In this article, we’ll understand what structured notes are, which are offered to investors, and how they can be used in portfolios.

Introduction: What are structured notes in investing?

A structured note is a debt security issued by financial institutions.

Structured notes are investments sold by banks that are designed to give investors a degree of downside security.

Structured note is a hybrid security, where approximately 80% is a bond component and 20% is an embedded derivative component.

The bond portion of the note takes up most of the investment and provides principal protection.

The rest of the investment not allocated to the bond is used to purchase a derivative product and provides upside potential to investors.

Traditionally used by institutional investors or in the private banking space with the ultra-wealthy, structured notes are now available to most investors through the investment advisor or financial advisor.

Technology has provided access to many new customers making the market more competitive and transparent, with lower fees.

Globally, the structured note is a large market with more than $3 trillion outstanding. The first structured note was created in London in the mid-1970s.

Later it was made popular in Switzerland and Germany. Currently, structured notes are gaining a lot of attention and popularity in the market with increasing assets under management (AUM).

What are the basic components of structured notes?

What are the basic components of structured notes

First, let us understand and define the four basic components of structured notes.

Understanding these four features will help while looking at any structured note.

It will also give you an idea of the variables to balance risk and rewards while choosing or creating structured notes investments.

Structured notes may be linked to different underlying assets, differ in term lengths (tenure), and have protection options.

There’s also the level of return on a structured note or yield, that investors expect by using structured notes.

  • Maturity
  • Underlying Assets
  • Protection
  • Returns

Maturity: This is the period over which a structured note is held. Tenure ranges from 3 months to 20 years, and in most cases, it ranges between 2 years to 6 years.

Underlying Assets: The performance of a structured note usually tracks the performance of one or more underlying assets – an index, stock, group of stocks, commodities, interest rate, or currency – over the maturity period.

Protection: This is the level of protection an investor has against the decline in the prices of the underlying assets.

As long as underlying assets do not fall below the protection(barrier) level, the investor’s capital is protected and is not exposed to any capital loss.

Protection can be either hard protection or soft protection.

 

  • Hard protection: It is a more conservative type of protection, it works as a shield against losses. If the underlying price drops below the barrier level, the investor will only be exposed to losses past the barrier level.
  • Soft protection: This type of protection acts as a barrier against losses. If the barrier level is breached, the investor is exposed to the full loss of the underlying asset. Soft protection will potentially provide higher returns than hard protection since soft protection is riskier.

Returns: This is the amount that the investors receive over the term of the structured note or at the end of the term under different market conditions.

Investors may expect investment returns either through an income or growth of the underlying assets.

The income-based structured notes offer investors a fixed return with periodic coupon payments over the term of the structured note while the growth notes link the upward increase in the value of the underlying assets.

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Structured a Structured Note

Now, after understanding the four basic features of any structured note, let us understand the different “structures” for structured notes.

How does each type of structured note work in different markets? How should an investor determine the sort of structured note that should be invested in?

There could be much variety of structured notes which can be designed, in other words, there will be some type of structured notes for any type of investment goal.

There are four ways a structured note can be “structured”:

  • Downward market protection
  • Upside (or enhanced) participation
  • Regular payment/ income in the form of coupons if certain market conditions are met
  • Payout/ return at maturity if certain market conditions are met

If we compare with the bond market, an investor may invest in treasury bonds, corporate bonds, municipal bonds, emerging market bonds, etc.

These bonds differ in the scale of risk versus reward.

The core of a structured note is a zero-coupon bond issued by the bank with a derivatives package.

Structured notes can be quite diverse and cover a wide range of portfolio objectives. It has the feature of capital protection and upside growth.

As a means of hedging against price movements and volatility, an investor may also use options strategies.

Depending on the structure an investor is seeking, an investor may integrate investment strategies with the call, put, and binary options since structured notes include an options package.

Therefore, a structured note makes the vehicle effective and convenient with the flexibility of payoffs, maturity, and underlying assets.

The number and type of notes can be customized based on varying investors’ goals.

Advantages of Structured Notes

Advantages of structured notes

Structured notes are an important part of the financial products portfolio. Let us understand what are the advantages and importance to have in our portfolios.

 

  • Protection: The right structured note allows the investor to participate comfortably with the right combination of attractive returns and a high level of protection. Structured notes generally have a protection level that limits the significant loss of an investor, thus providing security and stability to one’s investment.

  • Diversification: Structured notes can offer to diversify your investment portfolio. It may also have a diversified underlying. Along with the bond, these notes also have an investment in much riskier derivatives. An average investor may shy away from investing in such assets directly.

  • Access: A structured note may give access to an asset class that was previously institution-only or hard to access.

  • Flexibility: Some notes offer low returns with high protection while others offer higher returns, even when the markets go down moderately. It is possible to construct virtually any kind of structured note using the many financial instruments available in the market. Even though structured notes have the potential to base their returns on market assets like stocks, currencies, and commodities, they have built-in protection against losses.
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Risks of Structured Notes

Like any traditional investment, investors are expected to hold the investment till maturity to earn a return from a structured note. And just like any other investment, structured notes bear risks as well.

Some of the disadvantages of structured notes are exposed to are:

 

  • Issuer Risk: If the issuer becomes insolvent or cannot make the payments on the structured products for any other reason, investors could lose some or all of their entire investment. A decline in the issuer’s credit quality is likely to reduce the market value of the product and therefore the price an investor may receive for the product if they were to sell it in the market may be lower.

  • Market Risk: Even though most of the structured notes come with protection (barrier), investors may still suffer losses if the underlying breaches the protection level. The more volatile the underlying is, the riskier the structured note becomes.

  • Liquidity Risk: Although all of the structured notes come with a guaranteed buy-back from the issuer, an investor may lose if they need to sell their investment balance before maturity.

Structured Notes in Portfolios

Investors want greater control of their investments with defined outcome investing.

Structured notes offer a powerful portfolio tool because of their flexibility and customization opportunities that can be customized to client needs.

Many investors use structured notes as a core holding. A structured note is linked to risk/return tradeoff by selecting any asset class where downside protection is desired.

They are also used as tactical holdings based on specific investment themes, sectors, or other trends in the structured note market that would be difficult to implement otherwise.

Market Environment affects Note Pricing

Returns/pricing of structured notes are dynamic and move with market variables. A sample of market variables and how they influence structured note returns as below:

Conclusion

It has never been more important, or more challenging, to find relevant investments that deliver attractive risk/return. But when it comes to positioning client portfolios, defined results can help.

Quadra Wealth’s partnering with different global issuers (like Goldman Sachs, Morgan Stanley, Citi Bank, Barclays, BBVA, etc)allows for creating a customized structured note for a given objective like income, growth, or protection.

You can view all the current structured notes which are open for subscription by clicking here.

It starts with choosing an underlying asset, tenure, and protection level – then we connect with leaders of global structured note issuers.

Are you being bullish? Soft protection and a higher rate of participation could work. Bearish? Peace of mind would be provided by hard protection.

Uncertain? For a steadier return stream, probably pick an income note or an absolute note that can be up while your underlying is down.

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