A structured note is a term used to describe a hybrid financial product that combines a bond with a derivative of some underlying benchmark. This benchmark may be a single asset; a portfolio of assets; an index; or some other measure. From the perspective of the investor (note holder), a structured note represents an obligation on behalf of the issuer to pay them in accordance with the terms of the note – structured notes do not represent ownership of the underlying asset(s). The return of a structured note is based on the performance of the underlying benchmark and the contingencies of the agreement. Two common forms of structured notes we will be reviewing below are the principal protected note (PPN) and the partially protected note.
PPNs are typically structured as zero-coupon bonds with an attached derivative that entitles the investor to receive either all or part of the principal investment at maturity plus an agreed upon return based on the underlying asset(s). For example, a structured note could be constructed by linking its return to TSX / S&P 500 Composite Index. A potential PPN may stipulate that: the repayment of the principal is guaranteed upon maturity with any return above the principal being contingent on the underlying index being valued within a certain range – say 0 and 4%. Any increase in value above this range is captured by the issuer in exchange for eliminating the downside risk of the index losing value. For example, if the return on the index is 3.2% for the year, the investor will receive a 3.2% return on each note purchased. If the return on the underlying portfolio is 8.4% then the investor will receive a 4% return on each note purchased. At maturity the payment of the principal amount will be repaid in full and the payments will conclude. This would give the investor partial exposure to the return of an equity index (TSX / S&P 500 Composite) without the typical risk associated with an equity investment. A product of this nature may be of interest to an individual with a low risk tolerance that is currently holding a portfolio of bonds and wants to diversify.
A structured note may also be issued with only partial principal protection. This agreement may include contingencies stating that if the underlying index were to fall by 50% or more then the investor is liable for those loses i.e. their principal investment will lose 50% or more of its value. It is also common to see issuers include redemption clauses where if the underlying benchmark were to increase by X% at any time within the life of the note, then the notes are called back and the principal investments are returned. For example, a structured note agreement may stipulate: the note will return a fixed 5% each year for 5 years with 100% of the principal to be returned at maturity. The principal return is contingent on the underlying benchmark not decreasing by more than 50%. In which case the principal return at maturity will reflect the full benchmark loss (50% or greater). However, the total investment loss will be buffered by the annual 5% payments received. Conversely, if the underlying index exceeds a gain of 30% at any time during the life of the note, the notes are retracted and 100% of the principal is returned. If the notes are retracted before the 5-year period has concluded, the investor is responsible for re-investing their now stagnate capital.
While structured notes are typically designed to eliminate most, if not all, the market risk associated with the underlying asset(s), they open the investor to default risk based on the creditworthiness of the issuing organization. Furthermore, structured notes are more of a niche investment and may suffer liquidity risk if the holder needs to sell their notes in a pinch. Often these investments lock up capital for several years with issuers not allowing redemption until a “lock-up” period has subsided.
The two examples of structured notes that have been discussed above, represent very simplified versions of potential structured notes. In reality, notes may include various contingencies that each work to alter the risk profile of the investment. To ensure your portfolio is being optimized and that you understand all the more complicated details of a structured note, it is recommended that you work with a financial advisor when purchasing structured notes.
Introduction to Structured Notes by Jeff McRae | July 30, 2020
About the Author: Jeff McRae is an Associate with Bristol Capital Management. Jeff works closely with our advisors and clients on tailor-made financial and retirement plans. He graduated from the University of Guelph with a degree in Economics and Finance. He was the Chief Economist of the Young Economist Society of the university.
Bibliography: Contact us at info@bristolcapital.ca for a list of sources.