Morne Patterson — How Structured Notes Work

Morne Patterson
11 min readMay 14, 2024

Structured notes, instruments issued by banks, include elements of bonds with derivatives which provide an interesting balance of risk and reward. These financial instruments are designed to offer investors downside protection while also presenting opportunities for returns linked to the performance of underlying assets like stocks, currencies, or commodities such as gold.

In exploring these structured notes, this article will consider the components that define these instruments and examine the different types available to investors. We will aim to highlight the advantages as well as inherent risks associated with structured notes.

Components of Structured Notes

Structured notes are complex financial instruments that blend characteristics of both bonds and derivatives to meet various investor needs. This section considers the essential components that constitute structured notes, providing a clearer understanding of their function and versatility in investment strategies.

Bond and Derivative Components

1. Principal Protection and Upside Potential

· The core of structured notes is split into two main components: the bond portion and the derivative portion. The bond component typically accounts for 70%- 80% of the investment, offering principal protection which ensures that investors are safeguarded against total investment loss (unless opted out by the investor for higher potential returns). Conversely, the derivative component, making up about 20%-30% of the note, is designed to provide the potential for enhanced returns based on the performance of a specified underlying asset.

Customisation and Risk-Return Adjustment

2. Embedded Derivative Strategies

· Structured notes include derivatives such as options (calls and puts) which adjust the risk-return profile of the debt obligation. These options allow structured notes to be tailored to specific market views and risk appetites, offering strategies for growth, income, or risk management. For instance, a call option might be used to gain additional exposure to stock price increases, while a put option can protect against declines in asset prices.

Asset Class Exposure

3. Diverse Underlying Assets

· The derivative component of structured notes can be linked to a wide variety of asset classes including stocks, commodities, currencies, or interest rates. This allows investors to gain exposure to different markets and sectors without directly investing in them, which can be particularly advantageous for diversifying portfolios or for targeted investments based on market predictions.

Protection Mechanisms

4. Types of Protection

· Structured notes offer various forms of protection against market downturns. Hard protection ensures that the investor does not lose their initial investment if the underlying asset performs poorly, typically by guaranteeing the return of the principal amount at maturity. Soft protection, on the other hand, provides a buffer against losses up to a certain threshold, beyond which the losses would affect the principal.

Maturity and Returns

5. Flexible Maturity Periods

· The maturity periods of structured notes can range significantly, from as short as six months to as long as twenty years. This flexibility allows investors to match their investment horizon with their financial goals, whether they are looking for short-term gains or long-term growth. Type terms generally range between 3 and 5 years.

6. Return on Investment

· Returns on structured notes can be structured in various ways depending on the specific terms of the note. Investors might receive regular coupon payments if certain conditions are met, or a lump sum at maturity that reflects the performance of the underlying asset. This can provide regular income or a final payout that potentially exceeds the initial investment, depending on the market conditions and the performance of the underlying asset.

By understanding these key components, investors can better assess the suitability of structured notes within their overall investment strategy, taking into consideration their individual risk tolerance, investment goals, and market outlook. Structured notes offer a versatile tool for those looking to enhance potential returns while managing exposure to risk, making them a valuable addition to a well-rounded investment portfolio.

Types of Structured Notes

Structured notes, with their many configurations, cater to a wide range of investment objectives and risk appetites. This section outlines the main types of structured notes available to investors, each designed with specific features to meet different financial goals.

Principal-Protected Notes

1. Guaranteed Principal Return: Principal-Protected Notes (PPNs) ensure that investors receive back their initial investment amount at maturity, regardless of the performance of the underlying asset. This type of note is ideal for conservative investors looking for security in their investment while still participating in market opportunities.

Reverse Convertible Notes

2. High Coupon Payments with Risk: These notes offer investors higher coupon payments in exchange for the potential risk of losses if the underlying asset depreciates. Reverse Convertible Notes are suitable for those who are willing to accept higher risks for potentially greater returns.

Leveraged Notes

3. Amplified Market Exposure: Leveraged Notes provide enhanced returns that are multiples of the performance of the underlying asset. These are tailored for investors who seek aggressive growth opportunities and are comfortable with the associated higher risks.

Income Notes

4. Customisable Income Generation: Income Notes allow investors to receive regular coupon payments, which can be customised according to their preferred payout frequency and risk levels. They can be of interest to investors focused on income generation.

Growth Notes

5. Participation in Asset Appreciation: Growth Notes offer investors the opportunity to benefit from the appreciation of an underlying asset, such as stocks or ETFs, while potentially limiting downside risks. This type is favored by those looking to balance growth with a degree of capital protection.

Absolute Notes

6. Balanced Performance Participation: Absolute Notes enable investors to participate in both the positive and a limited amount of negative performance of the underlying asset. This balanced approach is designed for investors who prefer a moderate risk profile.

Digital Notes

7. Conditional Coupon Payments: Digital Notes pay out a coupon only if the underlying asset’s value is above a predetermined threshold at maturity. This type of note is suited for investors who can tolerate the risk of no interim income in favor of a potentially higher payout.

Notes linked to Asset Classes

· Equity-Linked: Connected to the performance of shares.

· Commodity-Linked: Tied to commodity prices like oil or gold.

· Currency-Linked: Dependent on foreign exchange rates.

· Interest Rate-Linked: Linked to the fluctuations in interest rates.

· Credit-Linked: Based on credit risks or events related to specific entities.

Each type of structured note is crafted to address specific investor needs, from those seeking security with principal protection to others aiming for high returns through leveraged market exposure. By understanding the various types of structured notes, investors can better align their investment strategies with their financial goals and risk tolerance.

Advantages of Investing in Structured Notes

Structured notes are a sophisticated financial tool that offers many advantages for investors looking to diversify their portfolios and manage risk efficiently. Here are some key benefits:

Enhanced Return Potential and Cost Considerations

1. Higher Returns: Compared to traditional fixed-income investments, structured notes often provide the potential for higher returns, capitalising on market movements through embedded derivatives.

2. Cost Efficiency: While offering the chance for enhanced returns, structured notes also present a risk of underperformance or loss of principal, necessitating a balanced approach in investment strategy.

Market Access and Customised Investment Solutions

3. Unique Market Access: These instruments provide access to various market segments that may be difficult for individual investors to reach, allowing participation in broader financial movements.

4. Customisation and Safety: Investors can benefit from a combination of safety and returns, with options to make unique bets on market expectations tailored to their risk tolerance and financial goals.

Capital Protection and Income Generation

5. Principal Protection: A key feature is the capital protection at maturity, ensuring that investors receive their principal investment back, even if the underlying assets perform negatively.

6. Steady Income Streams: Structured notes can serve as a reliable source of income, providing regular coupon payments that offer financial stability and cash flow consistency.

Diversification and Risk Management

7. Portfolio Diversification: By offering exposure to specific market segments, structured notes help in diversifying investment portfolios, which can mitigate overall risk and enhance portfolio stability.

8. Pre-Diversified Portfolios: These notes often come as pre-diversified portfolios, balancing the risk-return trade-off efficiently and catering to various investment appetites.

Predictability and Market Adaptability

9. Predictable Outcomes: The conditions determining the outcomes of investments in structured notes are specified upfront, providing clarity and predictability in investment returns.

10. Adaptability in Various Market Conditions: Structured notes can be advantageous even in flat or slightly rising markets, making gains through cleverly structured payoffs.

These features make structured notes a compelling choice for investors seeking to enhance potential returns while managing exposure to risk, thus making them a valuable addition to a well-rounded investment portfolio. Each investor, depending on their individual risk tolerance and market outlook, can find tailored solutions within the realm of structured notes to meet their specific financial objectives.

Risks Involved with Structured Notes

Structured notes, while offering potential benefits, come with inherent risks that investors must carefully consider. This section examines these risks, emphasising the need for a comprehensive understanding before investing.

Complexity and Transparency Issues

1. Understanding Risks: The intricate nature of structured notes often makes it difficult for investors to fully grasp the risks and potential returns. Their complex structures, combining derivatives with traditional securities, can obscure the true risk profile.

2. Lack of Transparency: Information about the derivatives embedded in structured notes and their conditions may not always be clear or fully disclosed in the prospectus, leading to potential misunderstandings about the terms and protections offered.

Market and Liquidity Risks

3. Market Risk: The performance of structured notes is closely tied to the underlying assets, which can be volatile. Fluctuations in the market can significantly impact the value of the notes, potentially leading to losses.

4. Liquidity Concerns: Structured notes are typically not traded on exchanges, which can make them difficult to sell before maturity. This lack of liquidity necessitates a buy-and-hold approach, which may not be suitable for all investors.

5. Limited Secondary Market: The absence of a robust secondary market can lead to challenges in valuing the notes accurately, often resulting in the need to sell at a discount if liquidity is required before maturity.

Credit and Issuer Risks

6. Issuer’s Creditworthiness: Since the return of principal and interest payments on structured notes depends on the issuer’s financial health, there is a significant risk if the issuer faces financial difficulties or bankruptcy.

7. Unsecured Notes: In cases where structured notes are unsecured, there is no recourse to any underlying security or collateral. This increases the risk, as investors may face total loss of their investment if the issuer defaults.

Additional Considerations

8. Call and Cap Risks: Some structured notes include call provisions allowing the issuer to redeem the notes early, often at unfavorable terms for the investor. Additionally, caps on returns can limit the potential gains, even if the underlying asset performs well.

9. Foreign Exchange and Tax Implications: If the underlying assets are denominated in a foreign currency, investors face additional foreign exchange risks. Structured notes may also be subject to unfavorable tax treatments, impacting overall returns.

10. High Fees and Overpricing: The costs associated with creating and managing structured notes can be high, and these costs are often passed on to the investor, potentially leading to overpricing compared to simpler investment products.

Understanding these risks are important for investors considering structured notes as part of their investment portfolios. Each investor should assess their own risk tolerance and investment objectives in light of these factors, seeking professional advice if necessary to navigate the complexities of structured notes.

Applications and Investment Strategies

Structured notes, with their unique mix of derivatives and traditional bond characteristics, offer versatile applications in investment portfolios. These instruments can be strategically utilised to achieve various financial goals, from conservative risk management to aggressive market plays. Below, we explore how investors can incorporate structured notes into their investment strategies effectively.

Core and Tactical Holdings

1. Core Portfolio Holdings: Structured notes can serve as a fundamental component in a diversified investment portfolio. By balancing the risk and return through their inherent design, they provide a stable foundation that can enhance the overall portfolio performance while mitigating risk.

2. Tactical Market Positions: Investors can use structured notes to take tactical positions on specific market themes, sectors, or trends. This approach allows for targeted investments that capitalise on short-term market movements or specific economic conditions.

Managing Market Volatility

· Volatility Strategies: Utilising structured notes, investors can make unconventional bets on market volatility. For instance, notes linked to the VIX or other volatility indices enable investors to profit from market turbulence, providing a hedge against other portfolio risks.

Customised Investment Outcomes

· Outcome-Oriented Investments: Structured notes allow for the customisation of investment outcomes based on specific financial goals or market views. Whether seeking capital protection, income generation, or growth, these instruments can be tailored to meet diverse investor needs.

Investment Table: Structured Notes Strategies

Risk Management and Diversification

· Diversification Benefits: By linking to various underlying assets such as equities, commodities, or currencies, structured notes help diversify investment risks. This characteristic is great for building resilience in investment portfolios against market fluctuations.

· Risk Control Mechanisms: The design of structured notes often includes features such as caps or floors, which help manage and limit potential losses, making them an attractive option for cautious investors.

Strategic Financial Planning

· Long-Term Financial Goals: With options for varying maturity periods, structured notes can be aligned with long-term financial objectives, such as retirement planning or funding major expenditures.

· Advisory Tools: Investors are advised to utilise tools to determine their risk tolerance and identify structured notes that align with their investment profiles.

Structured notes offer a dynamic tool for investors, adaptable to a wide range of strategies from fundamental portfolio construction to specific, tactical market plays. Their ability to be customised makes them particularly valuable for investors looking to achieve specific financial outcomes while managing risk exposure.

FAQs

1. What exactly are structured notes, and how do they function?Structured notes are hybrid securities that merge the characteristics of various financial products, including bonds and other derivatives. They are designed to offer features of both debt and investment assets. Rather than being direct investments, structured notes function as derivatives that derive their value from combinations of these assets.

2. Can you explain what structured derivatives are?Structured derivatives are a category of financial instruments that have many terms, payout structures, and risk profiles based on a variety of underlying assets. These instruments derive their pricing in a complex manner from the interactions of multiple derivatives and/or cash instruments.

3. How do structured products operate in the financial market?Structured products are innovative investment solutions that link one or more underlying assets — such as shares, bonds, or stock indices — with a derivative component. This combination allows investors to potentially achieve positive returns in various market conditions, including when markets are not trending.

4. What constitutes a structured financial instrument?A structured financial instrument is a type of financial product whose performance or value is tied to an underlying asset, product, or index. This linkage could involve a variety of elements such as market indices, individual stocks or baskets of stocks, bonds, commodities, currencies, interest rates, or combinations thereof.

--

--

Morne Patterson

Morne Patterson is a positive, driven individual and considers himself to have good leadership skills. Visit:- https://mornepatterson.co.za