Structured notes are a type of fixed-maturity security that have both a bond component and embedded derivative. Their performance is linked to another asset or index such as an equity index, individual equity security, interest rate, commodity, or currency.
Learn more about what structured notes are, and what you should know before deciding to invest in them.
Definition and Examples of Structured Notes
Securities generally fall into one of three categories: debt, equity, or derivative. The most common example of a debt security is a bond. The most common example of an equity security is stock. Derivative securities are financial instruments that derive their value from an underlying asset. An example of a derivative is an options contract.
Structured notes are hybrid investment instruments that don’t fit neatly into one category. They feature both a debt component and a derivative component.
There are many different types of structured notes. Some common examples are:
- Principal protected notes
- Reverse convertible notes
- Leveraged notes
There are also hybrid notes that contain features from more than one of these types.
How Do Structured Notes Work?
The way structured notes work is a function of the securities underlying them. Like a bond, a structured note has a fixed maturity. Like a derivative, the return on a structured note is linked to the performance of some other asset.
For example, it could be linked to an equity index; the return on the structured note would depend on the performance of that index. The asset it is linked to is dependent on the derivative component contained in the structured note.
In addition to being linked to an equity index, a structured note could be linked to a single equity security, a commodity, or even a foreign currency. The asset the note is linked to will vary from note to note.
Structured notes are also unsecured. This means the issuing institution has not pledged any assets as collateral. The payouts are only as reliable as the financial position of the issuing firm, and they could default.
Structured notes are complex securities. They are designed by individual financial institutions, which means they can vary a lot. Depending on the type of structured note or who the issuer is they will have a prescribed payoff structure. Because of the large variation in structured notes, the payoff structure can vary significantly as well.
The payoff structure may include some of the following.
If the structured note has principal protection, you would receive at least a portion of your principal back no matter what. This would be true even if the asset loses value. Some structured notes may return up to 100% of your principal, although others protect as little as 10%.
Principal protection may go by other names, including capital guarantee, minimum return, or absolute return.
If the structured note contains a participation rate, you will receive, at a minimum, your principal back plus a fixed percentage of any increase in the value of the reference asset.
For example, if the participation rate is 25% and the reference asset increases by 25%, then you would receive 5% (which is 25% of 25).
Capped Maximum Returns
A structured note with a capped maximum return would only pay out up to the stated cap, even if the reference asset’s value increased by more. For example, if the return cap is 25% but the reference asset increases by 30%, you would only receive 25%.
This feature actually allows for the return on the structured note to be cut if the value of the reference asset drops below a certain value.
What It Means for Individual Investors
Structured notes are complex investments and might not be suitable for inexperienced or new investors. Unless you understand exactly how the structured note is related to the reference asset, and how this impacts the returns you can expect, these securities may not be a good choice for you.
Also, it is not enough just to know that the structured note is linked to the reference asset. Features such as participation rates, capped returns, and knock-in features don’t exist in many other investment products such as ETFs or mutual funds. You need to understand them and their implications for your potential returns before you start investing.
You should also understand that structured notes are less liquid than other, more common types of investments. These notes are not typically listed for trading on exchanges. Issuing institutions often state that they will not repurchase them once issued. This means you may need to hold the security until it matures, even if you need to access the money you put into that investment.
- Structured notes are complex hybrid securities linked to the performance of another asset.
- Investors should make sure they understand all the relevant features of a particular structured note before deciding to invest in one.
- Structured notes are illiquid, unsecured debt obligations of the issuer.