What are structured notes?
A structured note is a form of security or deposit instrument issued by a variety of issuers. These notes can be fixed or variable-income instruments. Structured notes can also offer a rate of return linked to the performance of some other financial benchmark, such as the value of an equity index, the direction of U.S. interest rates, or the price of a commodity.
In part due to the use of options, fixed-income structured notes typically offer a higher potential rate of return than current market rates. They have proved popular with investors looking to maximise returns in today’s low-interest-rate environment. In addition, equity-linked notes are popular with clients who want to invest in an equity market, but retain a level of capital protection.
How do they work?
Suppose that you buy a structured note linked to the Standard & Poor’s 500 Index when it stands at 1,200. For every year the index stays above, say, 1,300, the note will pay 4.5%, a rate of return higher than the prevalent interest rate. If the index does not stay above 1,300, then you will receive no return.
In many cases, a structured note offers protection for an investor’s capital by guaranteeing to pay back the original investment when the note matures. Still, they are considered to be riskier than conventional fixed-income investments because there is a greater potential for investors to receive no return.
Who are they suitable for?
There is a wide variety of structured notes available. They range from conservative fixed-income or equity-linked investments that have their principal protected, to more aggressive equity-linked or fixed-income-linked notes that pay a rate of return based on the performance of an equity index, a basket of shares, an individual commodity such as silver or gold, or the direction of a rate index. In some cases, a structured note will be created to meet the needs of an individual client.
The suitability of an individual structured note depends on the investor’s financial circumstances and tolerance for risk, so it’s important for investment advisors to fully understand the objectives of their client.
What role can a structured note play in an investor’s portfolio?
It depends on how the note is created. In our example, where the structured note is linked to the performance of the S&P 500, the note allows the investor to diversify into equities with principal protection. The investor gains exposure to the potential returns offered by equities, while protecting his or her initial investment.
Structured notes can be customised to fit your unique situation, and serve as a hedge to reduce overall investment risk.
For example, let’s say you own a distribution company and ship most of your items over land. Your financial situation depends a great deal on the price of oil. You could purchase a structured note with a rate of return that is linked to the price of oil.
If the price of oil rises, the structured note pays a higher return, which can help offset the negative effect that higher fuel prices would have on your trucking business.
What are the potential risks?
Because they can be customised, structured notes also tend to be less liquid than conventional fixed-income investments. Though they can be traded on some equity markets, there may not be an active trading market in them before their maturity date.
A structured note offers some participation in other markets, but the exposure may be limited, which also means the potential upside may not be as great as it would be if you invested directly in the market, although this depends on the path the index takes to maturity. If you are considering this type of investment, you need to keep in mind that different types of notes are subject to different regulations depending on the country you live in.