A structured note is a hybrid security that combines multiple payoffs from multiple securities, usually a bond and a derivative. The bond component makes up approximately 80% of the investment and provides principal protection to investors. The derivative component makes up the remaining 20% of the investment and provides upside potential to investors.
An example of a structured note is a bond with a 5-year maturity term that is linked to an options contract. The inclusion of an options contract changes the risk profile of the security, so it is close to the investor’s level of risk tolerance. The arrangement allows investors to invest in asset classes that would otherwise be considered too risky to invest in.
A structured note refers to a hybrid security that is made of a derivative and a bond component.
A structured note is linked to an underlying asset, such as stocks, commodities, interest rates, and currencies.
The issuer of a structured note makes coupon payments to investors during the term of the note.
How Structured Notes Work
Traditionally, structured notes were used by institutional investors and ultra-wealthy individuals due to their high-risk, high-return characteristics. However, it has changed in recent times, as technology has made it easy for investors to invest in structured notes at a reduced cost.
Structured notes use derivative securities to create the best possible “bells and whistles.” It makes the investments more attractive to investors. A derivative security is an investment that derives its value from another asset, such as stock, currency, commodity, market indexes, and interest rates.
Key examples of derivative securities included in structured notes are call and put options.
A call option provides investors with the right to purchase a security at a predetermined price within a defined time frame. If the holder exercises the right granted by the options contract, the seller has an obligation to sell the asset.
A call option comes with a certain life, and once the term expires, the option becomes invalid. In comparison, a put option gives the holder the right – but not an obligation – to sell a security at a specific price and within a specific time frame. If the put option is exercised, the put option writer is obligated to purchase the asset from the put option seller.
Basic Components of Structured Notes
There are four basic components of structured notes that investors can use to decide which variables to choose and adjust when investing in structured notes. They include:
Maturity refers to the period over which an investor holds the structured note. Generally, the maturity period of structured notes can vary from six months up to 20 years.
2. Underlying Asset
A structured note is linked to an underlying asset, such as a stock, commodity, interest rate, index, or currency. Some structured notes may have two or more underlying assets at the same time. The underlying assets are sometimes known as reference assets or benchmark assets.
When investing in structured notes, investors expect to receive a return over the holding period of the note if certain market conditions occur. Investors can expect to earn a return either through an income or growth of the underlying asset.
The income component provides investors with a fixed return with periodic coupon payments over the life of the asset, while the growth component relates to the upward increase in the value of the underlying asset.
When investing in structured notes, investors receive protection against declines in the price of the underlying asset. The protection amount ensures that the price of the underlying asset does not decline below the protection amount. It ensures that investors receive their entire principal amount and are not exposed to further losses.
The protection provided can either be hard protection or soft protection. Hard protection provides a buffer against losses such that, if the underlying price declines below the protection level, investors are only exposed to the losses incurred past the protection amount.
On the other hand, soft protection exposes investors to the full losses of the underlying asset if its price declines below the protection level.
Risks of Structured Notes
When investing in structured notes, investors expect to hold the investment until maturity to earn a return from it. However, like other investments, investors bear the risks that come with structured notes that could render the investment worthless.
Some of the risks that structured notes are exposed to include:
1. Liquidity Risk
Structured notes lack an established trading market, and if an investor wants to sell the security before the maturity date, they can only do so in the open market. There may or may not be ready buyers for the structured note, and investors may be forced to sell the investment at a discount of what it is worth.
2. Market Risk
Although some structured notes come with built-in protection levels against losses, investors may still suffer losses when the underlying asset becomes volatile to the risks of the market they are tied to. Linking the structured note to more speculative assets increases the market risk significantly.
3. Default Risk
Structured notes carry a higher default risk compared to other investments. If the note issuer files for bankruptcy, the entire investment could be rendered worthless, regardless of the returns produced by the underlying asset.
For example, when Lehman Brothers filed for bankruptcy, all of the Lehman Brothers structured notes were rendered worthless, and investors lost their entire investment held with this note issuer.
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