Structured Note: What It Is, How It Works, Common Types

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 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 return.

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 performance of a structured note is linked to the return on 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.

Advantages of Structured Notes

The flexibility of structured notes allows them to provide a wide variety of potential payoffs that are difficult to find elsewhere. Structured notes may offer increased or decreased upside potential, downside risk, and overall volatility.

For example, a structured note may consist of a fairly stable bond coupled with out-of-the-money call options on risky stocks. Such a combination limits losses, while creating the potential for large gains. On the other hand, it could lead to repeated small losses if the call options are too far out of the money.

More frequently, a structured note will offer limited losses in exchange for limited gains compared to other assets. For instance, the structured note might be linked to the S&P 500, with gains capped at 10% and maximum losses set at 15%.

Finally, structured notes can also be used to make unconventional bets on specific outcomes. A structured note might depend on stock market volatility, as measured by the VIX. A different structured note based on bull put spreads might offer significant gains even in flat markets. However, such a note would have high downside risk when the stock market has small losses.

Disadvantages of Structured Notes

Derivatives are complicated, even when they are not combined with other financial products. For instance, commodities futures contracts require specific knowledge on the part of the investor to understand their full implications. That makes a structured note a very complex product, as it is both a debt instrument and a derivative instrument. It is vital to know how to calculate a structured note's expected payoffs.

Market risk is prevalent in all investments, and structured notes have pitfalls. Some structured notes have principal protection. For the ones that don't, it is possible to lose some or all of the principal. This risk arises when the underlying derivative becomes volatile. That can happen with equity prices, interest rates, commodity prices, and foreign exchange rates.

Low liquidity is often a problem for holders of structured notes. The flexibility of structured notes makes it difficult for large markets to develop for particular notes. That 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. Thus, great care must be taken when investing in a structured note. Buffer ETFs are a more liquid alternative to structured notes for investors who are looking to limit losses in exchange for smaller potential gains.

Structured notes also suffer from higher default risk than their underlying debt obligations and derivatives. If the issuer of the note defaults, the entire value of the investment could be lost. Investors can reduce this default risk by buying debt and derivatives directly. For example, it is possible to buy U.S. Treasury bonds from the government and buy options separately. That would protect most of the funds from default risk.