Investors who want a trifecta of market exposure, decent upside and protection from losses might take a closer look at structured notes.
These fixed income securities are a relatively new type of investment, first launched in the U.K. in the early 1990s. Today, structured notes are gaining in popularity in the U.S.
While structured notes might appear to offer a winning combination, investors should understand they can be quite complicated and come with certain downsides.
What Are Structured Notes?
Structured notes are a type of debt security sold by banks, financial institutions or corporate borrowers.
Like other fixed income securities, investors loan money via structured notes for a fixed term. Unlike bonds and certificates of deposit (CDs), structured notes do not pay a fixed interest rate.
According to Michael Collins, a chartered financial analyst (CFA) and finance professor at Endicott College, the investment returns from a structured note depend upon the performance of one or more underlying assets. These assets can include stocks, bonds, commodities and currencies, or a basket that combines several of these asset classes.
“The structure of the note defines exactly how the return is calculated,” says Collins. “These notes also include some sort of protection against losses should the underlying asset lose value.”
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Structured Note Example
Let’s say you buy a three-year structured note that generates returns based on the performance of the S&P 500. If the S&P 500 finishes higher over this term, the note will pay you 1.15 times the index’s return.
If the S&P 500 goes up 10% over three years, you would earn 11.5%. The note may even have a cap of 25%, meaning this would be the most you could earn even if the S&P 500 goes up by more.
The note might also promise that if the S&P 500 finishes the term down by 30% or less, it will give you all your money back. However, if the market finishes down more than 30%, you take the loss.
Let’s say you put $100,000 in this structured note. If the market falls 30%, you break even and get your full $100,000 back. However, if the S&P 500 falls 35%, you also lose 35% and only get $65,000 back.
Payouts and Taxes for Structured Notes
The way a structured note handles payouts depends on its design. Some only pay out their returns and your money back at the end of the agreed term. You won’t get any money or income before then.
Others make quarterly income payments, similar to a bond. Like any investment, you decide between the tradeoff of having more upfront income and safety versus a potentially higher return over the long run.
How your gains from a structured note are taxed depends on how the note was designed, says Sunwook Jin, a certified financial planner (CFP) with Redwood Financial Network.
“Returns could be paid out as a form of interest, meaning they would be taxed as ordinary income, or they could be capital gains,” says Jin.
Structured notes have become popular investments for retirement. If you hold them in an individual retirement account (IRA), differing tax treatments would be moot.
How to Buy and Sell Structured Notes
You can buy structured notes using an online broker platform like Ameriprise Financial or Fidelity. They will connect you with the financial institutions that package and sell notes.
The minimum investment to buy a structured note can be quite high. It’s often around $250,000 according to Milind Mehere, founder & chief executive officer of Yieldstreet.
For smaller investments, you could use an alternative investment platform like Yieldstreet, which combines your money with other investors to buy structured notes.
If you’d like to sell your structured note before the end of the contract, there are secondary markets available through your broker, but Collins warns this can be difficult.
“Structured notes are often illiquid, which can make them difficult to sell prior to maturity,” says Collins. You might not be able to find a willing buyer, or if you do, they may only buy your note for a significant discount.
Advantages of Structured Notes
Higher Returns
Collins says that structured notes have higher potential returns compared to other debt investments like traditional bonds. They also add extra diversification to your portfolio by adding more types of investments.
Diversification can reduce risk of losses because you’re spreading across different asset classes and not having all your eggs in one basket.
Downside Protection
Even though structured notes base their returns on market assets like stocks, currencies and commodities, they have built-in protection against losses. This makes them potentially safer versus investing directly in these market assets.
Customization
Customization is a big advantage of structured notes.
“You get to choose an asset type, which can be broad or narrow,” says Jin. “They have flexible terms from less than a year to multiple years.”
In addition, you can choose between structured notes that prioritize income and downside protection or those with more upside and growth potential.
They Enable Complex Investment Strategies
You could potentially design an investment portfolio that offers the same result of a structured note, using a combination of options, stocks, bonds and other investment positions.
However, with one purchase you get the result from a structured note versus building all this on your own, which takes considerable time and investment expertise.
Disadvantages of Structured Notes
Lack of Liquidity
If you want your money back from a structured note before it matures, it can be difficult if not impossible. There isn’t an active secondary market for these investments. You might have to sell at a significant loss or even have no choice but to wait until the note matures to get your money back.
Credit Risks
Jin warns that structured notes are unsecured loans to financial institutions.
“Suppose the issuer is financially stressed,” says Jin. “They may be unable to repay their obligation.”
You should check the credit rating and financial status of a company to make sure they’re secure before buying one of their structured notes.
Chance of Missed Payments
Structured notes have a higher risk of missing payments compared to regular bonds.
For example, let’s say the underlying investment temporarily crashes the day before your structured note matures. Even if the investment recovers shortly after, you would miss out on your return and even lose some of your contribution because of bad luck. This is especially important if you buy a structured note where your entire payout is based on the return on the underlying asset and doesn’t include ongoing income payments.
Some structured notes also have a call option from the issuer. The issuer could decide to take back the structured note ahead of schedule, in exchange for a pre-agreed payment. Therefore, you wouldn’t get all the planned income and investment returns.
High Fees
The structured note issuer could charge fees well above what you would pay for setting up the same investment portfolio yourself, using options, stocks, bonds and other assets.
Who Should Buy Structured Notes?
Structured notes could be a good fit for sophisticated investors who can figure out all the terms behind their arrangements.
However, if you’d like to buy one directly from an issuer, your portfolio must be large enough to make a six-figure investment. With online alternative investment platforms, you could buy into pools of structured notes for a smaller amount.
Jin thinks that structured notes could be useful for investors looking to diversify beyond traditional investments like stocks, bonds, mutual funds and exchange-traded funds. He also suggests them for more conservative investors worried about stock market losses.
Collins agrees that structured notes could be useful for diversification and that they can provide a return above traditional bonds. He does warn that they are complex instruments, which can make them difficult to understand and value.
If you are thinking of buying a structured note, consider speaking with a financial advisor first to make sure you properly understand the rules, restrictions and risks of these investments.
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