Structured Notes: The Double-Edged Sword of Investing- Unveiling the Pros and Cons You Need to Know
In this article, we will examine the PROs and CONs of structured notes to help you determine if this alternative investment is appropriate for your investment portfolio.
What Are Structured Notes & How Do They Work?
Structured notes are a type of debt issued by investment banks. The return is typically based on the performance of one or more underlying reference assets, which can incorporate features like leverage, principal protection, and downside protection, to name a few.
The underlying reference assets may include individual stocks, debt securities, indexes, commodities, interest rates, foreign currencies, and baskets of these reference assets or market indexes like the S&P 500 or the Nasdaq.
Structured notes are unique because they have a hybrid of bond and stock characteristics, thus increasing investor appeal.
- Fixed maturity
- Usually pays coupons
- Receive initial investment back (depending on the structure)
- There could be an upside or downside based underlying asset’s performance asset
- You could lose your initial investment (depending on the structure)
Generally, the greater the potential upside, the more likely the structure note will have stock-like characteristics. Meanwhile, the safer the investment,e.g. principal protected or limited upside, the more likely it will behave like a bond.
PROs of Structured Notes
Structured notes provide a unique investment opportunity for retail investors. There are endless payout structures that can be designed, often too difficult to replicate through traditional investing mechanisms.
Asset Exposure Without Owning The Underlying
One of the most significant advantages of structured notes is that you can gain exposure to an underlying asset(s) without owning the security. This is advantageous if an investor wants a directional view of the markets but cannot hold the underlying asset.
Customized Payout Structure
Another pro of structured notes is that they can be designed to offer an endless number of unique payout structures that are difficult for retail investors to replicate without buying and selling complicated option structures, which can be nearly impossible for a retail investor to execute without significant investment knowledge.
Some common structures include leverage, increased yield, downside protection, principal protection, or even a buffered note which offers enhanced return with a contingent amount of downside protection.
Some (but not all), structured products offer capital protection, meaning you will not lose your initial principal invested. This is advantageous because investors can still earn higher returns than possible in a Certificate of Deposit.
Principal-protected structured notes are a significant pro for those looking for income generation while minimizing potential capital loss.
The last pro of structured notes is they can save investors time.
Sure, individuals could reconstruct a structured note using a combination of call, put, and spread options amongst other underlyings. But doing so is time-consuming and risky because one tiny mistake can disrupt the entire strategy.
Structured notes do the work for you, allowing you to spend more time on things you actually enjoy.
CONS of Structured Notes
At first glance, structured notes can be a seemingly ideal investment opportunity – but things aren’t always what they seem.
Below are some of the common disadvantages of structured products.
The biggest con of structured notes is that they are not easily bought or sold on a secondary market.
Unlike stocks and bonds, there is no public exchange like the NYSE, making structured notes more of a buy-and-hold-to-maturity investment.
If you want to exit your investment before maturity, you can often sell it back to the issuing bank, but you will likely take a 1-2% hit on the fees from either the investment bank, the broker, or maybe both.
The lack of liquidity is probably the most significant con of buying structured products.
Many structured notes offer call features enabling the issuing bank to call back the note and return an investor’s initial deposit.
In many cases, structured notes are non-callable for 1 or 2 years and then callable quarterly thereafter.
During the no-call period, the note may even offer what is colloquially referred to as a ‘teaser rate’ during those first 2 years, providing an above-average coupon to the investors.
If the trade is moving against the issuing bank and they are losing money, they may exercise the call option after the no-call period expires.
Note: Many structured notes are usually non-callable for 1 or 2 years after issuance and then callable quarterly after that.
Even though you are buying a structured product and not the underlying asset, the value of the structured note after it is issued largely depends on the performance of the underlying asset(s).
Structured notes can have high fees. Notes are usually sold by brokers and can have up to a 2% commission.
This fee is usually embedded into the note price, so investors do not see the fees unless they read the term sheet, which is often filled with complicated investing jargon.
For example: A broker may buy a note from an investment bank worth $980. Then, they will sell it to retail investors for $1,000, pocketing $20 or a 2% commission.
Subject to Bank Credit Risk
The last potential disadvantage of structured notes is that they are subject to the credit risk of the issuing bank. If the issuing bank fails, there is a possibility that you could lose some or all of your initial investment.
While experts agree that banks are much more stable after the 2008 financial crisis, it is still a risk investors should be aware of. During the 2008 financial crisis, structured product investors saw the value of notes issued by Lehman become virtually worthless overnight due to the company’s bankruptcy.
The Bottom Line
Structured notes can be a tempting investment opportunity. However, as the saying goes, ‘if it’s too good to be true, it probably is.’
If used correctly, structured notes can benefit an investor’s portfolio by adding diversification, hedging your portfolio, or aligning your portfolio to a particular market or economic view.
The problem is that many individuals don’t read the fine print (I mean, really would you?) and get ensnared by high teaser rates and above-market returns.
Structured notes can be complicated. It is imperative that you understand the factors that can impact your returns; otherwise, you could lose some or all of your principal.
So before you jump headfirst into a structured product, you should ensure the note aligns with your investment objectives and perform thorough due diligence before investing.