What Is a Structured Note?
A structured note is a debt obligation that also contains an embedded derivative component that adjusts the security's risk/return profile. The return performance of a structured note will track both that of the underlying debt obligation and the derivative embedded within it.
This type of note is a hybrid security that attempts to change its profile by including additional modifying structures, thus increasing the bond's potential returns.
[Important: Products like mortgage-backed securities (MBS) and commodities futures contracts require knowledge on the part of the investor to understand the financial implications.]
Understanding Structured Notes
A structured note is a debt security issued by financial institutions; its return is based on equity indexes, a single equity, a basket of equities, interest rates, commodities or foreign currencies. The return on a structured note is linked to the performance of an underlying asset, group of assets or index.
All structured notes have two underlying pieces: a bond component and a derivative component. The bond portion of the note takes up most of the investment and provides principal protection. The rest of the investment not allocated to the bond is used to purchase a derivative product and provides upside potential to investors. The derivative portion is used to provide exposure to any asset class.
An example of a structured note would be a five-year bond coupled with a futures contract on almonds. Common structured notes include principal-protected notes, reverse convertible notes, and leveraged notes.
Potential Risks of Structured Notes
Derivative products, on their own, are complicated. Products like mortgage-backed securities (MBS) and commodities futures contracts require knowledge on the part of the investor to understand the financial implications. This makes a structured note a very complex product, as it is both a debt instrument and a derivative instrument. It's important to understand a structured note's payoff structure and payoff calculation.
Market risk is prevalent in all investments, and a structured note is sometimes exposed to high levels of this risk. Some structured notes have principal protection, but for the ones that don't, it's possible to lose some or all of the principal, based on market risk. This risk arises when the underlying derivative becomes volatile, as is the case with equity or commodity prices and interest rates or foreign exchange rates.
Liquidity is a problem that comes up when investing in a structured note. These types of notes are not listed for trading on security exchanges. This makes it very hard to buy or sell a structured note on a secondary market. Investors who are looking at a structured note should expect to hold the instrument to its maturity date and should thus be careful when choosing a derivative component.