The Innovative Aspects of Structured Notes
Today many clients have challenges trying to generate income while limiting risk in the current low-interest rate environment. One possibility to consider for clients with the appropriate risk profile is structured notes.
What are Structured Notes?
Structured notes are securities issued by financial institutions whose returns are based on equity indices, a single equity security, a basket of equity securities, interest rates, commodities, and/or foreign currencies. The client’s return is linked to the performance of a reference asset or index.
Structured notes have a fixed maturity and include two components – a bond component and an embedded derivative. They are considered hybrid securities that combine the features of both traditional fixed income instruments and derivative exposure into one security. They typically have maturities from one to 10 years.
What to Expect with a Structured Note: How it Works
Structured notes are indirect investments that derive coupon payments from the optionality of the underlier. The performance of the structured note depends on the performance of the underlying derivative subject to the issuer’s credit quality.
Let’s look at a simple example. A bank issues a growth structured note with point-to-point participation based on the percentage increase on the S&P 500 index. This note has a 25% downside protection referred to as a ‘buffer’ which means your principal is protected for up to 25% of losses. The return is based on the underlying derivative for the note which is an option on the S&P 500. The note’s value over time is a function of the issuer’s credit quality and market performance of the derivative.
Ideally, if the note matures in one year and the S&P 500 has increased 10%, the investor receives 10% return and principal upon observation date. If the S&P 500 falls 20%, the 25% buffer kicks in and the investor receives just their principal at maturity. If the S&P falls 30%, the buffer absorbs 25% of losses and the investor experiences 5% loss on their principal at maturity. It should be noted, there is no guarantee on bond principal as it is subject to the credit quality of the issuer.
When to Use a Structured Note
Structured notes can be beneficial since they offer investors flexibility in risk-return options and can be personalized for their unique portfolio. Since structured notes have the characteristics of both principal protection and potential upside, they can be designed many ways and cover a wide range of portfolio objectives.
Basically, notes can be structured to participate in market growth and enhance income. If growth is a goal, they can be designed to help provide additional protection when the underlying market drops, or to produce additional gains when the market rises in the underlying securities.
On the income side, structured notes may pay coupons that depend on the performance of the underlying benchmark. On observation date, the coupon payment will only be paid if the contingency is met. The note can be structured with buffers or barriers to provide downside protection. Of course, there is always a trade-off between the amount of market exposure/growth and the amount of risk protection that each structured note offers.
Some structured notes are designed to return 100% of principal at maturity. Examples of principal protected notes include CD’s which are insured by the FDIC to the applicable limit(s) and principal protected notes that are backed by the issuer. It is important that clients who invest in structured notes understand the level of principal protection associated with them.
Overall, structured notes offer flexibility in the payoff, maturity, and underlying investment which makes them both efficient and convenient for certain investors.
Types of Structured Notes
A few examples of structured notes include:
- Principal Protected Notes: A structured product that protects your initial principal investment regardless of the performance of the underlier via FDIC insurance or issuer protection. Principal protected notes are subject to the credit of the issuer and market risk in the event of early liquidation. These investments are tailored for risk-averse investors wishing to protect their principal while participating in gains from favorable market movements.
- Market-Linked Notes: An investment product that can provide income or growth. These notes can include varying levels of principal protection with the use of buffers and barriers. Market-linked notes typically have higher yields due to the return linked to the underlying derivative. This type of structured note can vary in risk tolerance and can be suited for moderate and speculative investors depending on the note.
- Customized Structured Notes: An investment product designed to meet specific investor needs. Notes have flexibility in design of the payoff, maturity, and underlying investment to tailor a note to fit an investor’s unique portfolio needs. Customized products can have a higher degree of pricing complexity and lower liquidity than calendar products. HilltopSecurities’ fixed income desk can help structure custom notes for advisors with issuing banks.
Structured notes have some important considerations that include the credit risk of the issuer, costs and fees, liquidity, and pricing complexity. Certain “retail notes” come with FDIC protection up to the applicable limits. For those that are not insured by the FDIC, the investor assumes the issuer’s credit risk.
Additionally, structured notes may carry higher costs and fees than other investments. Details about costs and fees can be found on the issuer’s offering documents, and it is important for an investor to review such documents carefully with their financial advisor when considering complex investments such as structured notes.
The term of a structured note investment is typically one to 10 years, so they are considered long-term investments. They are also considered to have limited liquidity with no guarantee of a secondary market. Structured notes are designed to be held to maturity. For sales prior to maturity, there is a secondary market for structured notes and the issuing bank generally provides a bid but has no legal obligation to repurchase the note. Investors are subject to market risk if they sell the note prior to maturity.
Structured notes can be difficult to value given their complexity and liquidity. Complex investments require sophisticated financial valuation models to price them accurately, and such models may not factor in each possible outcome or likelihood. The bid price for a structured note in the secondary market or from an issuer may differ from the model-based mark-to-market shown on an investor’s statement.
To learn more about structured notes and if they might be right for your clients, please contact Alex Loreto or Katie Buchgraber on the HilltopSecurities’ taxable trading desk.
AVP, Fixed Income Trading Assistant
Hilltop Securities Inc.
Direct: (214) 859 1380
717 N. Harwood Street, Suite 3400, Dallas, TX 75201
Katie (Wittwer) Buchgraber
Senior Vice President, Trader
Hilltop Securities Inc.
Direct: 214.859.6621 | Fax: 214.859.6887 | Mobile: 408.887.7941
717 N. Harwood Street, Suite 3400 Dallas, TX 75201
For more information about Momentum Independent Network, contact Wealth Management at WealthManagementInfo@hilltopsecurities.com or 833-4HILLTOP.
Structured notes are complicated products that are subject to various risks including changes in interest rates, market valuations, low liquidity, default risk, and other factors.
The paper/commentary was prepared by Momentum Independent Network (MIN).
Momentum Independent Network Inc. is a registered broker-dealer and registered investment adviser that does not provide tax or legal advice. MIN and HilltopSecurities are wholly owned subsidiaries of Hilltop Holdings, Inc. (NYSE: HTH) located at 717 N. Harwood St., Suite 3400, Dallas, TX 75201 (214) 859-1800, 833-4HILLTOP. Member FINRA/SIPC
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