What Are Structured Notes?
Structured Notes (Products) are financial instruments issued by banks, primarily aimed at safeguarding the principal of investors, boosting returns, or generating income.
These products are crafted to generate returns that mirror the behavior of a foundational asset, frequently being a stock index, an exchange-traded fund (ETF), or a solitary stock, leading to their occasional designation as “market-linked bonds.”
How Do Structured Notes Work?
At its core, a structured note merges a zero-coupon bond with a derivatives ensemble, primarily consisting of options for buying or selling, which act as a strategic defense against the unpredictability of the market. These derivatives are meticulously crafted to navigate through market volatility, offering a financial instrument that balances risk and reward.
Most of the investor’s principal is allocated to a zero-coupon bond from the issuing bank. Upon maturity, the bond yields the original investment plus accrued interest to the investor. Simultaneously, the portion dedicated to the derivatives ensemble contributes to the amplified returns and safeguards the investment.
Advantages of Structured Notes
The advantage of these financial products lies in the investor’s ability to predetermine both the return methodology (the manner in which the investment yields returns) and the extent of capital exposure (the potential financial loss). This approach provides investors with a sense of predictability throughout the investment’s tenure. The return profiles can be very thouroughly structured to capitalize on uptrends, downtrends, or stagnant market phases, and can be customized to align with individual investor preferences.
Common Structured Note Strategies
Enhanced equity exposure with reinforced profit potential and risk mitigation.
Alternatives to fixed income that offer increased yields.
Intelligent substitutes for cash holdings, backed by FDIC insurance.
Current Landscape
In recent years, structured notes have gained traction among financial advisors and individual investors, driven by easier access, clearer information, enhanced liquidity, reduced fees, and better education.
Fintech platforms have simplified access to these investments, enhancing their transparency. With interest rates at historic lows, investors are seeking other income sources. Structured notes appeal for their market downturn protection.
The structured note market has swelled to over $3 Trillion, with a historic $91 Billion issued in 2021, marking a 26% rise from 2020. Each year it has increased significantly. 2024 is on track to set another record.
History of Structured Notes
Structured notes have a long-standing global presence, gaining significant traction among European retail investors since the 1980s, especially in Switzerland, Germany, and the UK, before spreading to Asia in the 1990s.
In the US, structured notes started gaining momentum among investors in the mid-1990s. However, high entry thresholds, sometimes up to $1 million, limited their reach to the very affluent and institutional investors, while a general lack of awareness and resources among financial advisors and investors hindered their widespread adoption.
Risks of Structured Notes
Like any financial vehicle, structured notes come with their own set of risks, making them not ideal for every investor. These risks include, but are not limited to the following:
Call Risk:
Some structured notes are callable or redeemable at the option of the issuer. If called, an investor may be unable to reinvest the proceeds with similar or better terms to the original investment.
Creditworthiness of the Issuer:
Structured notes are unsecured obligation of the issuer and therefore are subject to the risk of default. The issuer’s creditworthiness is an important consideration when evaluating any structured notes.
Fees:
Structured notes are subject to fees and costs, which may include amounts payable to a financial professional, structured and development costs, and offering expenses.
Dividend Risk:
Structured Notes do not participate in dividends. Structured notes are linked in the price return of the underlying asset and derive their market exposure from options, which don’t produce dividends.
Liquidity Risk:
Typically, the issuer will maintain a secondary market; however, there is no obligation to do so. There may be little to no secondary market available.
Potential Loss of Principal:
Investors will not participate in any price appreciation of the underlying asset nor will they receive dividend payments generated by the underlier. Notes are not principally protected, and investors can lose some or all their initial investment.
Market Risk:
Volatility and other market forces, such as interest rate fluctuations and inflation, can affect the value of the underlying asset, which can affect return. Historical performance of the underlying asset is no guarantee of future performance.