Investors looking to diversify and add protection to a portfolio typically add asset classes like high quality bonds. While relatively safe, you can sacrifice long term returns since the yields on these bonds are eroded by inflation.
Innovative investors can look to a product called structured notes to better align their portfolios with their goals.
While they can appear overwhelming at first, implementing structured notes in a thoughtful manner can be a powerful way to enhance your investing experience.
Structured Notes: A Primer
First, let’s examine what structured notes are.
Structured notes are financial products issued by banks. Major banks like JPMorgan, BNP Paribas, and Bank of Montreal are all issuers of structured notes. Globally, it’s a $3 trillion market.
At its core, a structured note is a zero coupon bond with a package of options contracts. Though it’s an asset class of its own, it can be thought of as a stock/bond hybrid because they exhibit characteristics of each.
Every structured note has four components:
- Term: a predetermined maturity date, which typically lasts 18 months to five years.
- Underlying asset: the performance of the note tracks the price performance of one or more underlying assets, commonly a stock index.
- Payoff: the amount to be received during the life of the note or at maturity.
- Downside protection: a level of protection the investor receives if the underlying asset loses value.
At maturity, as long as the underlying asset doesn’t fall below the level of protection, the note will pay back the initial investment in full, which is an attractive feature of structured notes.
Next, let’s assess two ways structured notes can be used in a portfolio.
Growth with Protection: Preserving Capital in Volatile Markets
Growth notes are one type of structured note designed to track the price performance of an underlying asset. An investor would choose to do this in a structured note because of the added benefit of downside protection and, perhaps, upside leverage.
Consider a hypothetical note that tracks the price performance of the S&P 500 index and the NASDAQ-100 index.
- Term: 3 years
- Underlying assets: S&P 500 index, NASDAQ-100 index
- Principal barrier: -30% at maturity
- Participation rate: 130%
In this scenario, the return after three years will be the price performance of the lower of the two indexes with 130% upside leverage. For example, an index return of 30% would mean the note would return 39% (30% x 130%).
If the worst of the underlying indexes was negative after three years, the investor would receive back his original principal if the index was not below the barrier of -30%. This level of downside protection makes this note attractive in a volatile market.
If the index was below -30%, the investor would receive the same loss as the underlying asset (i.e., -35% index loss = -35% loss on the structured note).
This type of note can be suitable for someone who is already investing in stocks and likes the enhanced upside and a level of downside protection.
Income Notes: Generating High Yields
Structured notes can also be designed to pay income. In this type of note, income continues to be paid as long the underlying assets don’t fall below a certain level. In other words, the income (coupon) is contingent upon the performance of the underlying assets.
While this type of note is not designed to grow in value, the investor receives his principal at maturity if the underlying asset is also above the principal barrier.
Let’s examine a hypothetical income note with the following terms:
- Term: 3 years
- Underlying assets: S&P 500 index, NASDAQ-100 index, Russell 2000 index
- Coupon: 0.83% per month (10% per year)
- Coupon barrier: -30%
- Principal barrier: -30% at maturity
This note will look at the price levels of the three underlying assets every month and compare them with their starting values. Because this note has a -30% coupon barrier, the coupon will be paid each month if all three of the indexes aren’t lower than -30%. If one or more indexes falls below the coupon barrier, coupon payments will be skipped until the price goes back above that barrier.
At maturity, the investor will receive his original principal as long as the principal barrier isn’t breached (similar to the growth note example). If one or more of the underlying indexes is lower than -30%, the note will lose value.
Customization: Tailoring Risk and Return
While all structured notes have some level of downside risk, the beauty of structured notes is their ability to be customized to target a specific risk, return, or portfolio goal.
For example, a conservative investor can increase the coupon and principal barriers of their note. If a -30% principal barrier isn’t enough, they can look at -40% or even -50%.
Underlying assets can also be customized to reflect your view or portfolio application. While using major stock indexes can be prudent, some investors might want to track specific stock sectors, commodities, or single stocks.
While not covered here, some notes can be structured in a way to provide a positive return even in moderately negative markets.
Risks and Considerations
Usually, the first question people ask is, “What’s the catch?” With structured notes, it can seem like a proverbial free lunch. But with every investment, there are opportunity costs and risks to consider.
First, you don’t get the dividend of the underlying index. The S&P 500 currently has a dividend yield around 1.5%. If you had a 3-year structured note with the S&P 500 as the underlying index, that’s around 4.5% of return you don’t receive. Hopefully the leveraged upside would make up for the loss of that dividend.
Second, if you own an income note you do not get potential growth of the underlying asset.
Third, structured notes have a limited secondary market. Unlike an ETF or a mutual fund that you can sell or redeem at any time, selling a structured note prior to maturity means getting a bid from the issuer or another buyer, much like selling an individual bond.
Fourth, the ultimate risk of structured products is the credit risk of the issuing bank. Since these are bonds of the bank, it’s important to evaluate their creditworthiness and to diversify among different issuers.
Structured notes offer a compelling blend of growth or income with a level of downside protection. Their ability to be customized to fit an investor’s goal means they can be used in a variety of ways. It’s for this reason that some investors should consider them as an additional tool for their portfolios.