Structured notes are an oft-overlooked investment product since they aren’t widely publicized to retail investors and often come with rigid investor requirements. However, if you qualify and have a means to access structured notes from a reputable (and financially stable) investment firm, they may offer you the guaranteed returns you can’t get anywhere else – leveraged gains in an upward market and hedged/range-bound returns in a downward market. Investors in the right structured note products during the recent downturn where US equities lost 50% or more are main street’s envy now.
What are Structured Notes?
Structured notes generally deliver an upward return while limiting downside risk by utilizing an underlying instrument such as a zero-coupon bond, while relying on the remainder to mimic an index or commodity with derivatives such as options or leveraged instruments.
In short, depending on the structured product you’re in, you could have a max downside of break-even while enjoying returns upwards of 20% when the market rallies.
Not to be confused with promissory notes or the high yield investment notes offered by the likes of Advanta with enticing yields of 11%, but wrought with risk (see Advanta investment note review), the risk of these notes (also sometimes referred to as principal protected notes) is also that of solvency of the issuing firm, but some of the “survivors” of the recent financial meltdown are the issuers, so the likelihood that the government would allow the likes of JPMorgan to fail after TARP, TALP and all its brethren is very low. Taxpayers and politicians alike don’t take well to the “sunk cost” philosophy as evidenced by the GM bankruptcy debacle where they continued to throw good money after bad while the most basic evidence indicated it was a lost cause.
How do Structured Notes Work?
An example Structured Note could be as follows: The retail investor purchase a structured note for $1000. The issuer guarantees that in 2 years’ time, the principal will be returned, at a minimum. So, they look at the interest rate of a risk-free asset like Treasuries or whatever proxy they’re using and invest say, $900 in that instrument. This $900 is guaranteed to be worth $1000 at the end of the term (this assumes of course that the institution still exists). With the remaining $100, they invest the funds in say, an out of the money stock option, a currency instrument, leveraged ETF, swaps, or whatever you agree upon based on the structured product. I built a model like this myself utilizing CDs and options in my Financial Model#1 article at Everyday Finance. The example I just relayed is the simplest structured product and is easy to mimic. They get increasingly complex and can deliver additional protection and leverage if you’re eligible to participate – read on…
Here’s an example of a more complex Structured Note offered by JPMorgan.
The graphical representation below demonstrates that anything to the left side of the dotted line is basically “beating the index” which occurs whether the S&P500 is up or down on the year, up to a cap of 20%, at which point, you’ve maxed out your gain. The returns are essentially +10% of market return on any market loss during the period (i.e. market tanks 12%, you only lose 2%) and it’s a 2X leveraged gain from 0-10% S&P, but then caps at +20%. Surely, investors would have traded a 40% loss for the prior year’s 50% loss from peak and wouldn’t mind a 2X return during a mild upward move from here if that’s what the market has in store.
And they get more complex from there. There are literally thousands of different combinations of structured products. Some of them allow for a greater loss, with leveraged gains, some allow for a guaranteed range within a small window, there are several different indices and asset classes that can be tracked, etc. Search around and you may find one that fits that you qualify for.
What Risks to Structured Products Present?
- Issuer Solvency/Credit Risk – This is the most prominent risk, especially in today’s environment where some of the largest institutions have either folded or required significant government assistance to remain a going concern. As indicated previously, much of this risk has already been assumed by the government in the form of partial ownership in the firms, warrants, and flat-out political hat-eating if the assisted firms fold, so it is unlikely to see widespread carnage on Wall Street again in the near future. If you are insistent upon investing in a structured product, but are overly concerned about the solvency of the issuer, you could always “hedge your hedge” buy buying a way out of the money (usually $2.50 is the lowest denomination) put on the firm during the term. While that put option may cost you some money, it is likely to be so far out of the money that it will be virtually free, but if matching the number of options to the value of a zero dollar stock with your maximum principal loss, you could easily do so.
- Lack of Liquidity – Generally, the issuer firms do not allow the structured products to be sold prior to maturity, and if they do, there is probably not a substantial secondary market and your investment may be subject to redemption fees and penalties. It’s definitely not as straightforward as breaking a CD.
- Complex Tax Treatment– Due to “imputed annual income”, you’ll need to pay taxes on imputed annual income on the structured note even though you don’t receive the principal + gains until the end of the term…of course, consult your accountant for formal tax advice relevant to your particular tax situation.
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