munKNEE.com Your Key to Making Money
Today’s post explains what structured notes are, outlines the two main types, and demonstrates how to implement them in a portfolio.
What is a Structured Note?
A structured note is a hybrid security, where approximately 80% is a bond component and 20% is an embedded derivative.
Structured notes are issued by major financial institutions. Since they are the liability of the issuer, it is critical that the investor is comfortable with the issuer—as with any bond purchase.
Almost all structured notes have four simple parameters.
- Maturity – The term typically falls within 3 to 5 years.
- Payoff – The amount the investor receives at maturity.
- Underlying asset – The note’s performance is linked to the price return (excluding dividends) of an asset, such as stocks, ETFs, or foreign currencies.
- Protection – The level of protection the investor receives if the underlying asset loses value. As long as the underlying asset does not fall lower than the protection amount at maturity, the investor will receive their initial investment back in full.
This is the primary draw of structured notes: they provide a level of downside protection, while still allowing investors to participate in market upswings.
Types of Structured Notes
There are a variety of structured notes, providing investors with diverse options and a range of risk/return profiles. Structured notes generally fall into one of two broad categories: growth notes and income notes.
- Growth Notes
- Investors receive a percentage—referred to as the participation rate—of the underlying asset’s price appreciation.
- Income Notes
- Over an income note’s life, investors receive a fixed payment known as a coupon. Income notes do not participate in the upside returns the way a growth note does—but they may generate a higher income stream than a standard debt security or dividend-paying stock. This is because protection is offered for both the principal and the coupon payments…
- Income notes have another big advantage: their yields can spike in tumultuous markets, as was demonstrated during the market volatility near the end of 2018. Why did this spike occur? Banks construct the derivative piece of an income note by selling options, which are more expensive in volatile markets. Banks then collect these higher premiums, creating larger coupons inside the structured note.
Investors can diversify their return profile by using a combination of growth and income notes.
Portfolio Applications
Structured notes are powerful tools that can accomplish almost any investment goal, and investors commonly use them as a core portfolio component.
- Step 1: Select a portfolio asset class where downside protection is desired. The asset class will demonstrate an enhanced return profile, with less downside risk.
- Step 2: Reallocate a portion of the asset class to a structured note
- Step 3: Improve risk/reward performance.
A Global Market
While relatively small in the Americas, the structured notes market is growing on a global scale:
| Region | AUM (2019 Q2) |
|---|---|
| Americas | $434B |
| Europe | $526B |
| Asia Pacific | $1,066B |
In the first half of 2019, assets under management in the Americas was up by 4%. It’s clear the asset class presents enormous untapped potential—and investors are taking notice. As more investors take advantage of this asset class, they may be able to improve their return potential while limiting their risk.
Editor’s Note: The above excerpts are from the original article by VisualCapitalist.com, and have been re-formatted, color highlighted, edited ([ ])* and abridged (…) by Lorimer Wilson, editor of munKNEE.com – Your KEY To Making Money! – for the sake of clarity, and brevity to provide a fast and easy read.
*(The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)