Demystifying Structured Notes

Alternative investments do not correlate with the stock market and can produce gains when the overall market is down. Structured notes are one of the available alternative investments. These derivatives can diversify your portfolio, but it's important to understand how these assets work before jumping into them. This guide will cover how the asset class works so you can determine if it's the right investment for you.

How Do Derivatives Work?

Structured notes are a type of derivative, and knowing how derivatives work can help us better understand structured notes. A derivative is a securities contract made between 2 or more entities. Under a derivatives contract, one party agrees to purchase (or finance a purchase) a particular item from another party, but the value of the contract is tied to the price of an underlying asset.

One of the most common types of a derivatives contract is a "futures" contract, where one party agrees to buy something at a fixed price today and then pays that debt off by a certain date in the future. Payoff usually occurs when 1party needs access to large amounts of a commodity for an extended period of time but needs to guard against the price for that item spiraling out of control.

Imagine a national bakery chain that needs year-round access to wheat to supply its operations and meet its sales orders. On January 1, 2024, they might purchase a futures contract to buy 10,000 lbs of wheat at 10 cents/lb, which must be paid by September 30, 2024.

If the price of wheat stays steady at 10 cents, the baker breaks even. If the price of wheat goes up to 20 cents/lb by the end of the contract, the baker has saved 50% because they agreed to purchase it at .10 cents/lb. Additionally, the baker could also sell off any unused wheat they have at a profit. However, if the price of wheat goes down to 7 cents per pound by September 30th, the baker will have overpaid by 30%.

As you can see, the idea of buying at a fixed price now to guard against a sharp, unexpected price spike in the future makes a lot of sense for a commodities-oriented business, such as an airline (that buys fuel futures) or the bakery. It can also be lucrative for investors, but there is uncertainty. Investors have to correctly predict how prices move to realize profits which is easier said than done.

What Is a Structured Note?

Derivatives have a lot of profit potential as investment products, but they carry risks. On the other hand, secured lending, such as mortgage loans or bonds, carries comparatively less risk. The downside with secured lending is that with interest rates being so low, the loans don't have as much profit potential as some other investments. That's where the concept of a structured note comes into play.

A structured note is a type of hybrid security investment offering, which is usually issued by an investment firm or financial institution. The reason it's a hybrid security is that as opposed to using only loan interest as a profit vehicle, a structured note is tied to the future performance of a derivative component, also known as an underlying asset. The ultimate goal of a structured note is to increase the upside potential of large loans while at the same time minimizing default risk.

What Is in a Structured Note?

Most structured notes are split into separate parts: the first one is the loan or bond (which usually represents the bulk of the note), and the second one is the derivative (also known as the underlying asset). While there is technically no limit to the number or type of derivative that can be included with a structured note, the most common underlying asset is usually 1 of the following:

• Commodities futures (gold, oil, orange futures)
• Interest rates
• Currency exchange rates
• A combination of assets
• Stock indexes

The loan or bond portion of the structured note involves a promissory note signed by the issuer, which offers principal protection on the loan. The derivative component of the structured note has no security but offers high upside potential to investors. This high upside potential is basically the draw that brings investors to the table. The downside risk is theoretically minimized by the issuer, who promises to pay the loan.

Types of Structured Notes

While structured notes can be put together in a variety of different configurations, there are five basic types. The type of note varies depending on the underlying asset. Below is a list of the most common types of structured notes.

Currencies

This type of structured note ties the potential return to the performance of one currency vs. another (e.g., USD vs. GBP or yen vs. euro). Investors can lock in a certain exchange rate and assess how two currencies will perform.

Commodities

This type of structured note ties the potential return to the price of one or more commodities (gold, pork bellies, fuel prices). Many commodities are essential for civilizations and are more resistant to inflation than other assets. Gold can thrive during economic uncertainty and is one of many precious metals investors can trade.

Equity

This type of structured note ties the potential return to the price of a particular equity, a group of stocks or stock indexes. Some equity-based structured notes pay investors in stock shares as opposed to dividends when the note matures and the principal comes due.

Interest Rates 

This type of structured note ties the potential return to the performance of a recognized interest rate, such as that set by the U.S. Federal Reserve of the London Interbank Offered Rate (LIBOR). You can make trades based on how you believe the Federal Reserve will adjust interest rates in the future.

Credit

This type of structured note ties the potential return to a specific occurrence related to a loan or credit, such as the performance of a bundle of loans or the value of the collateral securing those loans.

Advantages of Structured Notes

Structured notes offer several advantages. These are the highlights:

• Potential upside and flexibility: An investment firm can tie the loan portion of a structured note to any asset or combination of assets to provide the ideal combination of principal protection and upside potential. 
• Limited losses: Structured notes can be constructed to establish a ceiling on gains and a floor on losses. For example, a structured note's underlying asset could be the price of oranges, but it may also include a maximum gain of 20% or a maximum loss of 15% on orange futures. A sudden oversupply of oranges can only result in a 15% loss instead of something more substantial.
• Diversification across assets: Structured notes can contain various assets. You can get exposure to assets through these notes that you normally wouldn't have exposure to in the stock market.

Disadvantages of Structured Notes

Structured notes have several advantages, but no investment is perfect. It is important to understand some of the disadvantages before investing in this asset.

• A ceiling on potential gains: The purpose of structured notes is to minimize risk and maximize profits. Minimizing risk comes with a cost: a profit ceiling. In the previous example with oranges, an investor's gains are capped at 20%. Even if oranges become more popular and experience a drastic supply shortage, the investor cannot gain more than 20% on the investment.
• Structured notes are more complex: Some investors prefer to put their money into an ETF and let the portfolio manager do the work. Structured notes are more complicated to understand. It's important to remember retail investors are competing with institutional investors when trading these assets. A large investment bank buying a portion of a structured note may have entire divisions that specialize in individual derivatives. That will help the bank make more accurate predictions of future outcomes of any derivative component tied to a structured note.
• The issuer can default: Under normal circumstances, the kinds of large investment banks that offer structured notes can pay off the bond component without a problem, but that's not always the case. If the issuing bank goes south on the bond, the derivative component is basically worthless. Even a structured investment product with principal protection can go downhill and leave investors high and dry in more ways than one.
• Liquidity: Usually the initial investment and any other monies put into a structured note must remain illiquid for the full term of the investment. More often than not, there is no secondary market, or at best, a very limited one, for investors to liquidate their share of a structured note if they need to.
• Credit risk: An investor who buys into a structured note is taking a credit risk on the issuing bank or financial institution while at the same time betting on a positive future for the underlying component of the note. 

Retail investors should carefully consider the investment objective and consult an experienced financial professional or investment adviser before buying a share of a structured product.

Investing in Structured Notes

Structured notes use derivatives in an innovative way to add upside to a standard financing contract or a private bond issue while also mitigating the risk involved.

While there are a number of potential positive outcomes of structured notes, they pose a particularly high risk for retail investors who are not well-versed in derivatives. Sure, a prospectus can give them an idea of what will happen to their investment in a perfect world, but it is not a perfect world. Things go wrong. Projections get missed and even large financial institutions with long histories of success sometimes default on the bond portion of a structured note.

However, wise bets on structured notes as an alternative investment can diversify an already strong portfolio and could yield very good dividends. As is the case with all investments, it's up to individual investors to figure out how much risk they can tolerate and if that risk is worth the reward.

Frequently Asked Questions