What is it, how it works, common types

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What is a structured note?

A structured note is a debt instrument that also contains a derivative component that adjusts security risk-return profile. The performance of a structured note will track both the underlying debt security and the derivative embedded therein.

This type of note is a hybrid security which attempts to modify its profile by including additional modifying structures, thereby increasing the bond’s potential yield.

Key points to remember

  • A structured note is a debt security that also contains an embedded derivative component that adjusts the security’s risk-return profile.
  • The return of a structured note is linked to the performance of an underlying asset, a group of assets or an index.
  • The flexibility of structured notes allows them to offer a wide variety of potential gains that are hard to find elsewhere.
  • Structured notes are complex financial products that suffer from market risk, low liquidity and risk of default.

Understanding Structured Notes

A structured note is a debt issued by financial institutions. Its performance is based on stock indices, a single stock, a basket of stocks, interest rates, commodities or foreign currencies. The performance of a structured note is linked to the performance of a underlying assetgroup of assets or index.

All structured notes have two underlyings: a bond component and a derivative component. The bond portion of the note represents the bulk of the investment and provides principal protection. The rest of the investment not allocated to the bond is used to purchase a derivative product and provides upside potential for investors. The derivative portion is used to provide exposure to any asset class.

An example of a structured note would be a five-year bond paired with a future contracts on the almonds. Common structured notes include principal protected notesreverse convertible notes and leveraged notes.

Benefits of Structured Notes

The flexibility of structured notes allows them to provide a wide variety of potential gains that are hard to find elsewhere. Structured Notes may offer increased or reduced upside potential, downside risk and overall volatility.

For example, a structured note may consist of a relatively stable bond associated with out of the money call options on risky stocks. Such a combination limits losses, while creating the potential for significant gains. On the other hand, it could lead to repeated small losses if the call options are too far out of the money.

More commonly, a structured note will offer limited losses in exchange for limited gains relative to other assets. For example, the structured note can be linked to the S&P500with wins capped at 10% and maximum losses set at 15%.

Finally, Structured Notes can also be used to make unconventional bets on specific outcomes. A structured note may depend on the volatility of the stock market, as measured by the VIX. A different structured note based on bull put spreads could offer significant gains even in stable markets. However, such a rating would have a high downside risk when the stock market experiences small losses.

Disadvantages of Structured Notes

Derivatives are complicated, even when they are not combined with other financial products. For instance, commodity futures require specific knowledge on the part of the investor to understand all their implications. This makes a structured note a very complex product, as it is both a debt instrument and a derivative instrument. It is essential to know how to calculate the expected gains of a structured note.

Structured notes are often too risky and complicated for individual investors.

Market risk prevails in all investments, and structured notes have pitfalls. Some structured notes have primary protection. For those who don’t, it is possible to lose some or all of the principal. This risk arises when the underlying derivative becomes volatile. This can happen with stock prices, interest rates, commodity prices and exchange rates.

Down liquidity is often a problem for holders of structured notes. The flexibility of structured notes makes it difficult to develop large markets for particular notes. It is therefore very difficult to buy or sell a structured note on a secondary market. Investors considering a structured note should expect to hold the instrument until its maturity date. Thus, one must be very careful when investing in a structured note. Buffer ETFs are a more liquid alternative to structured notes for investors looking to limit losses in exchange for lower potential gains.

Structured notes also suffer from a default risk as their underlying debt securities and their derivatives. If the issuer of the note defaults, the full value of the investment could be lost. Investors can reduce this risk of default by buying debt and derivatives directly. For example, it is possible to buy US Treasuries government and buy choice separately. This would protect most funds from default risk.

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