The advancement of technology in financial services has been a broadly positive development in recent years. For companies, technology and innovation have helped to streamline operations. Consumers, on the other hand, have benefitted through a combination of a greater variety of investment options, convenience, and improved access to financial services.
Structured notes are one example of this improved access. Traditionally, structured notes had a $1 million minimum investment. They were thus only available to high-net-worth or institutional investors, but they are now becoming more widely available.
The first structured products were transacted in the UK in the early 1990s before spreading throughout Europe, most notably in France and Germany. Although the European structured product market is the oldest globally, it has since been eclipsed by the Asia-Pacific market. In fact, the total sales of structured notes in Hong Kong alone exceeds the aggregate volume for the whole of Europe. In only 30 years, the global market for structured notes has grown to over $3 trillion.
But what exactly are structured notes?
Structured notes are a type of debt security sold by financial institutions, banks, or corporate borrowers. Like other fixed-income securities, investors loan money to financial institutions for a fixed term. However, unlike fixed-income securities, structured notes do not pay a simple fixed coupon. Instead, its return is based on underlying assets such as equity indexes, interest rates, commodities, or even foreign currencies. There are a variety of structured notes, providing investors with diverse options and a range of risk/return profiles.
Almost all structured notes have four simple parameters: maturity, underlying asset, capital protection, and payoff.
Maturity refers to the term of the structured note, which is generally around three to five years, though there are notes with terms up to 20 years. The underlying asset is the asset to which the note’s return is linked, such as an equity index. The capital protection of a note indicates the level of downside protection offered; generally, this is expressed as a percentage of the investor’s capital. The capital protection offered by structured notes is their primary draw to investors. The final parameter is the note’s payoff.
Structured notes generally fall into one of two broad categories: growth notes and income notes.
With growth notes, investors receive a percentage (referred to as the participation rate) of the underlying asset’s return. If, for example, you purchase a structured note that offers a participation rate of 150% and capital protection of 95%, and the underlying asset returns 10% over the life of the note, then the return of the note will be 15%. If, on the other hand, the underlying asset’s return over the life of the note was -10%, then the investor will receive 95% of their capital when the note matures, which represents a loss of only 5%. This is the capital protection in action. It allows investors to participate in market upswings while providing a level of downside protection.
Structured notes also allow investors to get exposure to a variety of asset classes.
A good example of this is the Global & Local BNP Paribas Oil participation capital protected note. It offers investors a participation rate of 365% with 100% capital protection. The note would thus deliver a return of 110% if the price of the underlying asset – West Texas Intermediate Crude Oil, in this case – were to increase by 30%.
Income notes have a slightly different payoff structure.
With income notes, investors receive a fixed payment (which is known as a coupon payment) so long as the performance of the underlying is above a certain level. This is referred to as the coupon barrier. If, for example, a structured note has a coupon rate of 8% and a coupon barrier of 90%, then the investor will receive their 8% coupon payment as long as the return of the underlying is greater than -10%. Income notes do not participate in the upside returns the way a growth note does, but they offer a higher income stream than a standard debt security or dividend-paying stock.
Structured notes offer investors a good degree of flexibility, but they are not without their risks.
Firstly, they are complex financial products which are difficult to understand. Derivatives are complicated even when they are not combined with other financial products. That makes a structured note a very complex product, as it is both a debt instrument and a derivative instrument. Another issue is credit risk. The risk is that the financial institution which issues the note fails to meet their contractual obligations. It is thus important to take the creditworthiness of the issuer into account. Credit ratings are an important tool to mitigate this risk. Notes from issuers that have credit ratings below investment grade should be treated with caution.
The last issue with structured notes is liquidity.
Investors are more likely to purchase new structured notes rather than purchasing existing notes on the secondary market. With a shortage of buyers, sellers must offer their notes at a substantial discount in order to attract buyers. This results in a capital loss for the seller. Structured note investors should thus expect to hold the instrument to its maturity date.
Structured notes are powerful tools that can accomplish almost any investment goal. They allow investors to either increase or decrease their upside returns, downside risk, and overall volatility. Growth notes allow investors to participate in various asset classes while limiting the risk of capital losses. Income notes allow investors to receive fixed coupon payments at higher rates than are available for most fixed-income securities. There are, however, some risks to take into account. Structured notes are complex financial products. It is thus easy for retail investors to take on too much risk or even too little risk, which could have dire consequences for their portfolios.
Investors should also note that selling a structured note before maturity will likely result in a loss of their capital. Finally, there is also the risk that the issuer of the note defaults on their debt, leaving structured note investors out in the cold.