To the ordinary investor, structured notes seem to make perfect sense. Investment banks advertise structured notes as the ideal vehicle to help you benefit from excellent stock market performance while simultaneously protecting you from bad market performance.
Who wouldn’t want upside potential with downside protection? However, investment banks (which are to some extent sales and marketing machines that focus on promoting their investment products) may not reveal that the cost of that protection can often outweigh the benefits. But that’s not the only investment risk you’re taking on with structured notes. Let's take a closer look at these investments.
- Investment banks issue structured notes, which are debt obligations with an embedded derivative component.
- The value of the derivative is derived from an underlying asset or group of assets, also known as a benchmark.
- Investment banks claim structured notes offer asset diversification, the ability to benefit from stock market performance, and downside protection.
- A major disadvantage of structured notes is that the investor must undertake significant credit risk in the event the issuing investment bank forfeits its obligations, as was the case with the collapse of Lehman Brothers in 2008.
- Call risk, lack of liquidity, and inaccurate pricing are other disadvantages of structured notes.
What Is a Structured Note?
A structured note is a debt obligation—basically like an IOU from the issuing investment bank—with an embedded derivative component. In other words, it invests in assets via derivative instruments. A five-year bond with an options contract is an example of one kind of structured note.
A structured note can track a basket of equities, a single stock, an equity index, commodities, currencies, interest rates, and more. For example, you can have a structured note deriving its performance from the S&P 500 Index, the S&P Emerging Market Cores Index, or both. The combinations are almost limitless, as long as they fit the concept: to benefit from the asset's upside potential while also limiting exposure to its downside.
What Are the Advantages of Structured Notes?
Investment banks advertise that structured notes allow you to diversify specific investment products and security types in addition to providing overall asset diversification. However, there can be such a thing as over-diversification, whereby overall returns can be negatively impacted. It is important to understand how a particular structured note achieves diversification. For example, is there a high degree of correlation between assets held in the note?
Investment banks also often advertise that structured notes allow you to access asset classes that are only available to institutions or hard for the average investor to access. But in today’s investing environment, it’s easy to invest in almost anything via mutual funds, exchange-traded funds (ETFs), exchange-traded notes (ETNs), and more. Besides that, do you think investing in a complex package of derivatives (structured notes) is considered easy to access?
The only benefit that makes sense is that structured notes can have customized payouts and exposures. Some notes advertise an investment return with little or no principal risk. Other notes offer a high return in range-bound markets with or without principal protections. Still, other notes tout alternatives for generating higher yields in a low-return environment. Whatever your fancy, derivatives allow structured notes to align with any particular market or economic forecast.
Additionally, the inherent leverage allows for the derivative's returns being higher or lower than its underlying asset. Of course, there must be trade-offs, since adding a benefit in one place must decrease the benefit somewhere else. As you no doubt know, there is no such thing as a free lunch.
What Are the Disadvantages of Structured Notes?
If you invest in a structured note, then you have the intention of holding it to maturity. That sounds good in theory, but did you research the creditworthiness of the note's issuer? As with any IOU, loan, or other types of debt, you bear the risk that the issuing investment bank might get into trouble and forfeit its obligation.
If that happens, the underlying derivatives can have a positive return, and the notes could still be worthless—which is exactly what happened to investors in 2008 during the collapse of Lehman Brothers structured notes. A structured note adds a layer of credit risk on top of market risk. And never assume that just because the bank's a big name, the risk doesn't exist.
Lack of Liquidity
Structured notes rarely trade on the secondary market after issuance, which means they are highly illiquid. If you need to get out for any personal reason or because the market is crashing, your only option for an early exit is to sell to the original issuer.
Should you need to sell your structured note before maturity, it's unlikely the original issuer will give you a good price—assuming they are willing or interested in making you an offer at all.
Since structured notes don’t trade after issuance, the odds of accurate daily pricing may be low. Prices are usually calculated by a matrix, which is very different than net asset value. Matrix pricing is essentially a best-guess approach. And it's the original issuer who does the guessing.
Other Risks You Need to Know
Call risk is another factor that many investors overlook. For some structured notes, it’s possible for the issuer to redeem the note before maturity, regardless of the price. This means it’s possible that an investor will be forced to receive a price that’s well below face value.
The risks don’t end there. You also have to consider the tax factor. Investors may be responsible for paying federal taxes on structured notes, even if the note hasn’t reached maturity and the investor has not received any cash. Also, when sold, the proceeds may be taxed at the ordinary income rate, rather than at the more favorable capital gains rate. Each offering is different, and the SEC advises investors to carefully read the prospectus of a structured product in order to understand the tax implications.
As far as price goes, you will likely overpay for a structured note, which relates to the issuer's costs for selling, structuring, and hedging.
Example of a Principal-Protected Note (PPN)
There are various different forms of structured notes. Let's take a look at how one of the most coveted types, the principal-protected note (PPN), works.
PPNs are advertised as very safe as they, in theory, come with no downside risk. The return of the initial investment is guaranteed by the issuer, on top of any gains. In reality, PPNs are not risk-free at all.
PPNs are exposed to credit risk, meaning if the issuer goes bust you get zero, and they often carry caps that take a lot of the shine off the assumed benefits.
Let's look at a hypothetical example of an 18-month structured note with principal protection linked to the returns of the S&P 500. Based on how its advertised, investors may think that if the index rallies 50% over the period they'll pocket all the gains and if the index dips in value they will get what they invested back. But that is not usually the case,
First, there are the fees to consider, which eat into returns. And, secondly, there are usually various conditions attached.
The more protection offered by the note, the higher the fee.
Caps: Read the small print
In the small print, you'll learn more about what the note actually offers. For example, the prospectus might state that the index cannot fall by more than 25%. That means if it does, your principal is no longer protected. Downside protection can be called a buffer or barrier. A barrier implies that you’ll lose everything if the index moves below the specified level. A buffer, on the other hand, means anything over the threshold will be forfeited. So, using the example above, if the index was down 50%, the note would be down 25%.
Gains can be capped, too. The prospectus may state that if the index rises by more than 25% you’ll only get the principal back and forego any gains.
PPNs may be subject to a maximum return ceiling and have conditions about getting the principal back. In all cases, you also forgo dividends.
Another major downside is that dividend payments aren't included. If you were investing directly in the S&P 500 via a mutual fund or ETF, you would be reinvesting those dividends over the 18 months. This is a huge deal.
For example, in 2021 the S&P 500 generated a total return, including dividends, of 28.41%. Strip out the dividends being reinvested and that return falls to 26.61%. That's quite a difference and can really add up over time, impacting gains and downside protection on notes with barriers and buffers.
What Is the Problem With Structured Notes?
Structured notes come with several drawbacks. They include credit risk, a lack of liquidity, inaccurate and expensive pricing, call risk, unfavorable taxation, foregoing dividends, and, potentially, caps limiting gains and principal protection.
What Is the Average Fee for a Structured Note?
Prices vary, though structured notes are renowned for being quite expensive. And their fees are not always easy to spot as they’re built into the notes’ principal value. In 2020, Morningstar discovered that the average embedded fee was as high as 2.9%.
What Is a Barrier on a Structured Note?
A barrier on a structured note generally implies that there is a threshold or limit. Specifically, in the case of notes with principal protection, it means getting your investment back is contingent on the linked benchmark not falling beyond a specified level.
The Bottom Line
Structured notes are complicated and may not be a suitable investment strategy for the average individual investor. The risk/reward ratio can often be simply too poor. The illustrations and examples provided by investment banks tend to highlight the best features while downplaying the limitations and disadvantages. The truth is that on a historical basis, the downside protection of these notes is limited, and at the same time, the upside potential is capped. In addition, consider the fact that there are no dividends to help ease the pain of a decline.
If you choose structured notes anyway, be sure to investigate fees and costs, estimated value, maturity, whether or not there is a call feature, the payoff structure, tax implications, and the creditworthiness of the issuer.
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