Structured notes are unique instruments designed to help investors achieve specific objectives in specific environments. Representing more than $3 trillion in assets globally, they have gained popularity in the U.S. market in recent years, and technology platforms have made these instruments more accessible to retail investors.
Investing in structured notes can be more nuanced than investing in traditional assets, and the pros and cons of investing in structured notes should be considered by both advisors and their clients when evaluating their strategy.
What are structured notes?
Structured notes are unsecured debt obligations issued by financial institutions, including some of the largest investment banks. These instruments combine a zero-coupon bond with embedded options designed to provide investors with customized and more defined investment outcomes. Three common types of structured products are market-linked growth notes, market-linked income notes, and market-linked CDs.
Structured notes can offer a wide variety of often complex payoff structures tailored to fit various investment goals and objectives, including market exposure with embedded downside protection features, or potential above-market income opportunities. Performance is typically linked to an underlying index, asset, or combination thereof. They can carry characteristics of both fixed income and equity, and their risk-reward profiles span the spectrum from conservative and income to balanced or aggressive.
These investments are issued either through custom instruments, or through monthly “off the shelf” offerings known as the calendar. The calendar is a curated list of structured note offerings listed each month for potential investment. Each structured note has its own CUSIP, so while each individual structured note is unique in this respect, investors are generally presented with similar opportunities from month-to-month. Domestically, approximately 10-15% of the structured note market is via calendar (i.e., “off the shelf” business). The remaining 85-90% of flows are custom/bespoke CUSIPS created specifically for client needs via traditional communication such as emails, conversations, and calls with the issuers.1
This legacy “call around” process done through traditional communication means has several inefficiencies. It is highly manual and resource-intensive, pricing can be opaque, and relationship managers must relay ideas and available products back to clients to determine suitability and necessary documentation.
However, advancements in technology have facilitated the development of platforms such as SIMON and Halo. These platforms present investors with a calendar and act as a centralized hub to price and trade standard products from multiple issuers, making price discovery, document generation, and distribution easier. This technology should drive fees and minimums lower, and it helps standardize the complex and varying terminology across different offerings by issuers. Such platforms have enabled retail investors to more readily access structured notes.
What are structured notes comprised of?
There are generally four components of structured notes:
- Underlier. The return for a structured note is based on the price return of a designated asset or reference index, interest rates, or designated spread. Examples of underliers would be the S&P 500 Index, an individual stock or basket of stocks, the price of oil, etc. Most of the time, an underlier is a single reference asset. However, investors may occasionally see a “lesser of” underlier; this type of underlier considers multiple reference assets and uses the worst performing one of them at maturity to determine the note’s payoff.
- Maturity. The term of structured notes is normally between one and ten years, although shorter- and longer-term investments are available. Maturity for most investments falls between one and five years. Structured notes should be purchased with the intent to be held to maturity, though the actual holding period may be shorter, as certain structured notes have embedded call features which allow the issuer to call the investments away prior to maturity if specific conditions are met.
- Expected payoff at maturity. Structured note investment returns are determined by formulas customized to fit a particular market outlook or viewpoint. Some investments offer principal protection guarantees while others leave principal exposed to losses at maturity.
- Protection from price declines in the underlier through different types of buffers.
Structured notes are unique and require a better working knowledge from all parties involved than most types of traditional investments.
|Structured notes – pros
|Structured notes – cons
|• Constructing better defined outcomes
• Use cases for different environments
• Improved investment accessibility
|• Credit risk
• Market risk
• Liquidity risk
• Difficult to analyze and classify
• Call/prepayment risk
• Due diligence burden
Due diligence required
Investors must do their homework and wade through complex and complicated disclosures to understand what they are getting with any structured note. This is no simple task and requires a concerted due diligence effort that is likely to consume more resources than due diligence on more liquid and transparent investment vehicles. Moreover, because structured note payouts and protection contingencies depend upon the performance of the underlier at maturity, the purchaser of a structured note needs to have an informed opinion on the range of outcomes for the market over that time frame. Investors should be prepared to spend considerable time and resources on structured note due diligence as part of their overall due diligence framework.
As the structured note market continues to expand domestically, the library of resources and tools for evaluating them continues to expand. Platforms such as SIMON and Halo are rapidly evolving to not only make a more efficient marketplace for structured notes, but to introduce education around the vehicles themselves. Volumes of digestible materials from writeups to short videos help advisors grasp the concepts surrounding these investments. These platforms also offer summaries of the various notes on their platforms. While these resources serve to gain comfortability with structured notes and a high-level overview of individual notes themselves, they do not replace a thorough due diligence program. Investors should read and understand all offering documents to make an informed investment decision.
Want to go even deeper into structured notes? Check out our white paper, “Structured Notes: Pros, Cons, and Risks.“