Morne Patterson — A Beginners Guide to Structured Notes

Introduction

Structured notes have become an important investment vehicle offering investors a blend of features. These hybrid securities are developed by combining traditional bonds with derivatives and offer both institutional and individual investors both diversification and tailored risk-return profiles. However, the nature of structured notes can be perceived to be complex, leaving many uncertain about their mechanics and implications. In this article I will aim to clarify how they work, their potential benefits, risks, and things which investors should consider before venturing into this space.

Structured Notes: A Hybrid Investment Tool

At their core, structured notes are financial instruments that include the characteristics of two commonly known asset classes: bonds and derivatives. This results in an investment which combines the relative stability of a bond’s fixed-income component with the potential of a derivative’s performance-linked element to generate higher returns. By integrating these two components, structured notes offer investors a unique proposition — the opportunity to participate in the upside of underlying assets while mitigating downside risk through the bond’s principal protection.

The Bond Component

The bond component of a structured note serves as the base upon which the instrument is built. Typically accounting for approximately 70%- 80% of the investment, this portion functions like a traditional bond, and could provide investors with coupon payments (investment returns) throughout the note’s term. This bond is issued by an Investment Bank and it is important to recognise that the principal protection is dependent on the Investment Bank’s (issuer) creditworthiness and ability to fulfill their obligations. In the event of the issuer’s bankruptcy or default, investors may face the risk of losing a portion of their initial investment. To mitigate this risk it is advised to ensure that the note is structured through an Investment Bank which is considered no less than investment grade (as per S&P ratings).

The Derivative Component

The remaining 20%-30% of a structured note’s composition is dedicated to the derivative component, which acts as the catalyst for potential upside. This derivative element is linked to the performance of one or more underlying assets, such as shares or indices. The derivatives included in the payoff structure typically comprises options and/or put calls and is governed by a predetermined formula, which dictates how the underlying asset’s performance translates into the note’s returns. As a result, the derivative component introduces an element of market risk, as the note’s performance becomes tied to the fluctuations of the underlying asset. Typically these options are geared and the upside delivered by the derivative is a multiple of the performance delivered by the underlying asset.

Structured Note Options

Structured notes comes in many different forms, with investors having many options, each option tailored to cater to specific investment objectives and risk appetites. Different types include:

Equity-Linked Structured Notes

These structured notes derive their performance from the movements of individual shares or share indices, providing investors with exposure to equity markets while mitigating downside risk through the bond component’s principal protection.

Commodity-Linked Structured Notes

As the name suggests, these notes are linked to the performance of specific commodities or commodity indices, enabling investors to gain exposure to sectors such as precious metals, energy, or agricultural products.

Currency-Linked Structured Notes

These structured notes track the fluctuations of foreign exchange rates, allowing investors to capitalise on currency movements while maintaining a degree of principal protection.

Interest Rate-Linked Structured Notes

These notes are tied to the performance of specific interest rates or interest rate indices, providing investors with an opportunity to benefit from fluctuations in the fixed-income market.

Credit-Linked Structured Notes

These structured notes are linked to the creditworthiness of specific entities or credit events, offering investors a means to gain exposure to credit risk while potentially mitigating losses through the bond component.

Tailoring Structured Notes

One of the key advantages of structured notes lies in their flexibility and capacity for customisation. Issuers can tailor these instruments to meet the specific needs and risk profiles of individual investors by adjusting various parameters, such as:

Maturity

Structured notes can be issued with maturities ranging from a few months to several decades, allowing investors to align their investment horizons with their financial objectives.

Underlying Assets

The selection of underlying assets is an important aspect of structured note design, as it directly impacts the note’s risk-return profile. Issuers can link the derivative component to a wide range of assets, including individual shares, indices, commodities, currencies, or even baskets of assets.

Return Structure

Structured notes can be designed to offer many return structures, such as enhanced returns, absolute returns, or downside protection. These structures often incorporate features like participation rates, caps on upside performance, or floors on downside performance, enabling investors to fine-tune their risk-reward preferences.

Protection Levels

Issuers can incorporate varying degrees of principal protection into structured notes, ranging from full protection to partial or contingent protection. These protection levels are typically achieved through the use of barriers or buffers, which act as predetermined thresholds that trigger specific payoff scenarios. Note that with any investment, lower risk means a lower return potential.

Liquidity Considerations

While structured notes are primarily intended as buy-and-hold investments, investors may encounter situations where they need to liquidate their positions before maturity. However, it is important to understand that structured notes are not listed on exchanges, and there is no guarantee of an active secondary market for trading these instruments. With that said accessing structed notes issued by a high quality Investment Bank typically does present the opportunity to exit the note early at a redemption fee which can range from 1%-3%.

Costs and Fees

Structured notes, like many financial instruments, are subject to various costs and fees that can impact an investor’s overall returns. One notable aspect is the initial estimated value provided by the issuer, which is typically lower than the note’s purchase price. This discrepancy arises due to the embedded costs associated with structuring the note and compensating the issuer for their efforts. Additionally, investors should be aware of potential ongoing fees, such as management or administrative charges, which can further erode their returns over time.

Regulatory Oversight

The structured notes market is subject to regulatory oversight by various financial authorities. These regulatory bodies aim to promote transparency, ensure investor protection, and maintain market integrity. Investors should familiarise themselves with the applicable regulations and guidelines to make informed decisions and understand their rights and responsibilities when investing in structured notes.

Assessing Suitability

Before investing in a structured note, investors must carefully assess the suitability of these instruments concerning their investment objectives, risk tolerance, and overall financial situation. Structured notes may not be appropriate for all investors, particularly those with limited investment experience. It is advisable to seek guidance from qualified financial advisors who can provide personalised advice and assist in evaluating the potential risks and rewards associated with specific structured note offerings.

Diversification and Portfolio Integration

While structured notes can offer unique investment opportunities, it is important to integrate them into a well-diversified portfolio. Diversification helps mitigate the concentration risk associated with any single investment and can potentially enhance overall portfolio performance. Investors should carefully consider the role structured notes can play within their broader investment strategy and allocate resources accordingly.

Continuous Education

The structured notes market is constantly evolving, with new products and strategies emerging regularly. To work through this landscape successfully, investors must embrace transparency and remain committed to continuous education. This involves staying abreast of market developments, regulatory changes, and emerging trends within the structured notes ecosystem. By embracing a culture of lifelong learning and seeking guidance from reputable sources, investors can make informed decisions and adapt their strategies as the market evolves.

Conclusion

Structured notes represent a unique investment opportunity of innovation and complexity within financial markets. While they offer investors the potential for tailored risk-return profiles and exposure to diverse asset classes, their complex nature necessitates a thorough understanding of their mechanics, risks, and implications. By understanding structured notes and equipping themselves with knowledge, investors can navigate this world with confidence, leveraging these instruments as valuable tools within their investment portfolios. However, it is important to approach structured notes with prudence, seeking professional guidance when necessary, and maintaining a disciplined and diversified investment strategy that aligns with one’s financial goals and risk tolerance.