What if I told you that there is an investment product that allows you to participate in the equity markets without all of the inherent risk? As you may have already guessed, there is such a product and it is called a structured note. Structured notes (or simply “notes”) can vary quite a bit in terms of structure. (No pun intended.) The purpose of this article is to introduce you to some of the basic mechanics of most structured notes so that if you ever come across one, you will feel a bit more confident when considering to include it as a part of your investment portfolio.
A structured note is an alternative investment, but don’t let that terminology scare you. What makes it an alternative investment is that it doesn’t fall into the same category as a traditional financial product such as stocks and bonds. It is not an equity (or ETF) and it’s not a bond, yet it has a bit of both elements in them. In the most general of terms, a structured note is a debt obligation issued by a bank with a derivative component linked to it. Yes, I know, more scary terms, but believe it or not, notes are not as complicated as they may initially seem.
So, let’s dive into it—what is a structured note?
Two Basic Types of Notes
Income notes: Income notes pay regular coupons based on the performance of the underlying securities (discussed in depth below). This type of investment could be good for an investor who requires a regular income throughout the course of the life of the structured note.
Snowball notes: Unlike income notes, snowball notes (also sometimes referred to as “autocall” notes) do not pay regular coupons. Instead, the annual coupons accumulate—or “snowball”—until the note matures. This type of note is typically most beneficial to an investor who doesn’t have an immediate need for the cash. As a result of this delayed payout, snowball notes offer higher rates of returns compared to income notes.
Now that we have a general understanding of the different types of notes, let’s take a look into the actual mechanics of notes. The best way to gain an understanding of notes is to examine the components that they’re made of:
Issuer
While many investors may gloss over this component, the issuer is by far the most important part of ANY structured note. The main reason people invest in notes is to mitigate risk. As such, you should be aware that the biggest risk with structured notes depends on the issuer. As every investor knows, every investment has risk. Even government bonds which are considered to be some of the safest of investments has some risk involved. Governments can default on their debt obligations no matter how unlikely.
Quality, low-risk structured notes are issued by large institutional banks. Think Morgan Stanley, Barclays, and BBVA just to name but a few. When you look at a factsheet for a structured note, one of the first things you will see is the issuer and they will normally include the credit rating for the institution. That is because the greatest level of the risk to the note is linked to the solvency of the institution. Obviously, the higher the institution’s rating, the safer the investment is considered to be.
In a nutshell, you should only consider notes that are being issued by solid financial institutions; that means institutions that you believe will still be around for the foreseeable future. Always check the credit rating of the institution when evaluating a structured note, as the solvency of the issuer is the primary risk factor.
Underlyings
The performance of a note can be linked to different assets such as an equity (or a basket of equities) or linked to an index or multiple indices. An example of a structured note linked to a basket of equities might be a note that is linked to the performance of MSFT, NFLX, and META, for instance. An example of a note linked to a basket of indices could look something like having the S&P 500, FTSE 100, and Nikkei 225. Bear in mind that there could be more underlyings or even as few as just one underlying depending on the note. The basic premise remains the same.
One last key point when notes are linked to a basket of equities or indices, typically the overall performance of the note is based on the worst performing asset. So essentially, when examining the performance, you just need to take a look at the “worst-performing” of the underlyings.
Capital Protection
Capital protection lets you know how much of your capital will be at risk at maturity. Investors invest in notes because of their capital protection; it’s a way of participating in the investment markets without taking on the full brunt of the risk. The actual amount of protection varies from note to note, but just in case you’re wondering, it can be as high as 100%, which means that aside from the inherent systemic risk, your initial capital is fully protected. You will see many structured notes that offer 60 or 70% protection, which means that the underlyings can be down as much as 40 or 30% respectively before any of your principal is at risk. And even in that case, if at maturity, the markets have declined past the protective barrier, your principal amount is only at risk “like for like” based on the percentage the market is away from its initial levels. In other words, if you have a note that has a 70% protection, if at maturity the markets are down 35%, only 35% of your initial investment is at risk.
An important point is that the capital protection is only significant at maturity. In the years before maturity the markets can be down well past the capital protection barrier and your initial investment will not be at risk. You still have time for the markets to recover depending on how close you are to the maturity date. So, in theory, your underlyings can be down quite significantly and if you still have a few more years until maturity, you should have ample time for markets to recover in your favor.
Strike Price/Date
The strike price is the price for each of the underlyings on the date the note goes “live”. This date is known as the strike date and it is essentially the date when the prices of the underlyings are set to determine how each of the underlyings is performing relative to the terms of the note. The strike price is a key element because it is the gauge used to determine the performance of the note.
An example of how the strike price would work, let’s imagine a note that consists of three equities or indices, each equity or index will have a completely different strike price relevant to the note because each equity or index trades completely differently—and sometimes in different currencies. For illustrative purposes, let’s say that we have a note that includes the S&P 500 as one of the underlyings. Again, just as an example, let’s say that on the strike date of the note, the S&P 500 is at 5,500. That 5,500 price will be the barometer of the performance of the S&P 500 underlying for the life of the note. This will be very relevant in the next section when we discuss observation dates.
Observation Date
Throughout the life of a note, there are predetermined dates when the performance of a note is scrutinized to determine exactly how the note has performed. These observation dates are usually monthly, quarterly, semiannually, or annually based on the strike date. So, if a note has a quarterly observation date, it will be taken into account every 3 months from the strike date; if it has a semiannual observation, the performance of the note will be observed every 6 months from the strike date; etc.
In the case of an income note, the observation date will determine if you are owed a coupon payment based on the performance of all the underlyings. A common example would be if all the underlyings are 80% of the initial strike prices, the coupon would be paid for that period. Some income notes come with a “memory” feature. This simply means that if one or more of the underlyings is below the coupon barrier level and you miss the coupon, you will have an opportunity to recoup any missed coupons if the underlyings recover and are above the coupon barrier during any subsequent observations.
In our example above, assuming the S&P 500 is the worst performing of the underlyings, the coupon of an income note with an 80% barrier would pay the income payment on the observation date as long as the S&P 500 is at or above 4,400 (80% of the 5,500 strike).
In the case of a snowball note, the observation date will determine if the note qualifies to be called early. Autocall refers to the note’s ability to call earlier than its maturity date if predefined price levels of the underlying are met on the observation dates. A common example would be if all of the underlyings are 100% of the initial level the note would automatically call early (autocall). If your note was to call early, you would get back your principal and any payments that you are owed for holding the note.
Again, referring to our previous example, and again assuming the S&P 500 is the worst performing underlying, it would need to be at 5,500 or higher in order for it to autocall early.
Term of Investment
It is important for you to know how long your money will be “tied up” in a structured note. In this sense, notes function very similar to a bond having a predefined investment period. The term for notes can vary widely—from months to several years. The key part is that the term is defined from the outset, and should be a part of your consideration depending on your investment time horizon. How soon would you need access to the funds you are investing?
It should be noted that many structured notes do have a secondary market which means you could get your money back earlier should an immediate need arise. However, you would be exposed to what the note is trading for in the market and it could be lower than your investment principal. Though it is good to know that there is a way for you to recoup your principal earlier in the event of an emergency, I would strongly suggest that not be a part of your overall investment strategy into notes.
Returns
This will be the most important component of notes for many investors, but honestly, it really doesn’t need to be considered until all of the parameters above have been weighed and analyzed. If the returns seem justifiable based on the criteria listed above—issuer, term of investment, underlyings, etc, then the note is worth considering adding to your investment portfolio.
When Are Structured Notes a Good Fit?
Structured notes work very well when markets are flat or are falling; or if there is looming uncertainty around the markets. Notes allow you to lock in returns regardless of the performance of the markets. In that regard, notes operate very much like a bond but with potentially higher returns because of the market correlation.
When Are Structured Notes Less Beneficial to Investors?
This is a tricky question but not for the reasons you may think. A simple answer is that notes are not very attractive to some investors when the markets are doing particularly well, especially when the markets are growing exponentially. Remember, your returns are fixed and already locked in. So the markets might be up 300% for the year (likely an exaggerated example), if you are holding a note that pays 13% annually, that is the max return you are entitled to. However, this is where the autocall feature becomes very critical. If the markets are performing particularly well, there is a good chance that the note will call early (because there is a greater chance that the underlyings are at or above their strike prices) and you’d be paid back your principal plus any accrued interest payments. At that point, you would have an opportunity to invest your money accordingly based on the market conditions at that time.
What makes this question “tricky” is that it can also depend on the investor and what their investment objectives are. Let’s say you are a long-term investor who has already accumulated a lump sum of money over your investment years—you have taken part in the ebbs and flows of the markets over the years, and you’ve come out on the other end with enough money to live off of and/or to pass on to loved ones. At this point, you’re no longer interested in riding the daily waves of the markets. Been there, done that. The only thing that you’re looking to do is ensure that you’re not dwindling away your lump sum through withdrawals and inflation. Due to the low risk, you’re happy to receive 7-10% per year knowing that your capital is protected therefore not having to worry about significantly depleting your hard-earned nest egg.
So, in summary, structured notes offer a balanced approach to investing by providing downside protection and competitive returns in various market conditions. While not free from risk, particularly regarding the issuer’s creditworthiness, structured notes allow for diversification and yield enhancement in a conservative investment strategy.
Whether you’re looking to preserve wealth, generate income, or diversify a portfolio, structured notes are a versatile tool that can serve multiple financial goals. Feel free to get in touch if you’d like to explore if structured notes fit your needs and risk tolerance—because, as with all investments, understanding is key to making the right choice.