Structured Note

 

What is Structured Note?

Structured Note is a debt instrument whose payoffs (interest or principal or both) are linked to another underlying asset, benchmark, or derivative, making the instrument an exotic instrument that can be understood by sophisticated investors only. Structured Note is a complex product that derives its payoff from another asset, index, benchmark, commodity price, derivative, and more such benchmarks.

These are custom instruments and do not have a set standard in their making. These instruments can be best termed derivative instruments because their return and principal are contingent on another asset’s return or value. It can be a mix of two instruments, with one instrument offering capital protection and the other instrument offering some return from volatile asset classes.

How does Structured Notes Work?

Structured Note gives an investor access to asset classes that he would not have otherwise had. These asset classes could be difficult to understand, extremely complex, or may require a large investment, to begin with. To bring these asset classes to common investors, investment banks bundle one asset class, which investors are comfortable investing in any other asset class, which is a desired investment but out of reach of the common investor.

Investors may choose the investment based on their risk appetite. Highly risk-averse investors may conservatively choose both the asset classes they want to be invested in. For example, providing a choice between an instrument with bond and index characteristics and an instrument with bond and stock options characteristics, a conservative investor may choose a bond with an index due to its relative safety.

Alternatively, the instrument can also offer a base return and an additional return based on an underlying asset class’s return. Some instruments also have a call provision which may ultimately limit the return for an investor. A structured note can also be linked to a credit event, which offers a payoff contingent on a credit-related event (such as a company defaulting). Such notes are commonly referred to as credit-linked notes.

Example of Structured Notes

Consider an instrument that offers a payoff linked to gold prices. The instrument may have terms such as the issuer will pay a return based on the prices of gold, or even the principal could be indexed to the price of the commodity. The upside of this instrument is that the investor will get access to gold investing, and the downside is the price risk involved in investing in gold.

Let’s say a gold mining company issues a bond (Face Value of $1,000) linked to the price of gold, wherein it pays the return based on the return in gold during the period. If the gold prices increase by 8% during the period, the investor will receive $1,080. Assuming another scenario where the principal payment is also linked to the gold price and the gold price declines 5%, the investor will then receive $950 in repayments.

Risks of Structured Notes

Most investors do not fully understand the risk when they invest in Structured Notes. Understanding the risk of these instruments is extremely complex. There are common risks applicable to major asset classes; then there are risks associated with the issuer, then are the risks associated with the combination of assets in the instrument.

Given below are the Risks of Structured Notes:

1. Default Risk: Like any other instrument issued by private parties, a Structured Note carries a high level of default risk. The issuing party may default on part or full payments if the market moves against it or if its financial strength goes for a toss. Investors should do astute due diligence on the issuer before buying into these instruments.

2. Market Risk: The presence of volatile instruments in the overall Structured Note equation makes these instruments susceptible to market risks. There have been many instances in the past of markets turning wildly against investors of such instruments.

3. Call Option Risk: In instruments that have embedded call options, the upside for investors is limited. When the market turns highly in favor of them, the issuer exercises the call option and takes all the benefits. This is even riskier when the downside protection is also not in the investor’s favor.

4. Liquidity Risk: Structured Notes are custom products and do not trade on exchanges. This makes them illiquid, and an investor will not have an easy exit from these instruments.

Advantages and Disadvantages of Structured Note

Given below are the advantages and disadvantages mentioned:

Advantages:

• Provides Access to Instruments Beyond the Investor’s Reach: Structured note provides a common investor with an investment alternative that he would not have been able to invest in ordinarily.
• Combines Two Asset Class Providing Diversification: Because Structured Note is a combination of two asset classes, it provides a natural diversification benefit, making it a good investment alternative for some investors.

Disadvantages:

• Complex and Difficult to Understand: The Structured Notes are extremely difficult to understand, and one can not fully understand the risk behind these instruments.
• High Fees and Expenses: Structured Notes carry high fees, which ultimately hit the returns of investors. The fees hurt even more if the underlying does not perform well, killing the returns further or maybe putting the returns in negative territory.
• High Risk: The risk involved in the structured note is much higher than many other asset classes, and the worst part is that the investor will not have an exit if the investment bet goes wrong. The investor will then be left with damaged merchandise.

Conclusion – Structured Note

The utility of Structured Note is debatable because, with the development in financial markets, there are very few instruments where investors can not take exposure directly. Structured Debt may, though, at times offer attractive investment opportunities. Investing in them is more of an art because not all of these instruments are investable. A little bit of due diligence can make these investments a work of skill rather than a work of pure luck.

There is also rampant misselling of these products because most investors rely on advisors’ who collect hefty fees from sales of these products. Investors should consult their independent advisors for the right advice about investing in these products.

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