Whats a Structured Note?
A structured note is a debt security issued by financial institutions. It has a debt component (the bond) and a derivative component. The bond provides principal protection (to some degree) and the derivative allows for exposure to an asset class. The derivative is either an asset, a group of underlying assets, or an index. This derivative offers only speculative profits, as the return is not guaranteed in its entirety.
A common set up is for a structured note to offer a capped lower bound in exchange for a capped upper bound.
Advantages
- Wide variety of payoffs
- Exposure to the market and potentially greater payout than just the bond
Disadvantages
- Market risk
- Low liquidity
- Default risk
How are Structured Notes Created?
Income vs. Growth Notes
Income notes pay interest payments. Most of these notes are callable, which allower the issuer to call the note early if the note becomes too profitable for the holder.
Growth notes do not pay interest payments. They provide more lucrative payoffs when they mature.
How are Structured Notes priced?
The Payout
The participation rate is a factor that is multipled by the performance of the underlying asset to determine how much the holder of the note will receive. For example, if the particiaption rate is 50% and the underlying asset increases by 10%, the holder of the note will receive half the return. Likewise, if the participation rate is 200% and the underlying asset increases by 10%, the holder of the note will receive double the return.
Another feature of a structure note is a capped maximum. This is the maximum return the holder will receive from the returns of the underlying asset. For example, if the cap is set at 25% and the underlying asset increases by 35%, the holder of the note will only receive 25%.
A buffer is a rate that protects the holder’s principal, should the underlying asset underperform. For example, if the buffer is set to 15% and the underlying asset results in a -12% return, the holder of the note will not be affected. However, once the buffer is breached, the holder of the note will lose some (or all) of their principal.
A buffer of 100% is what’s called, a principal protected note. This means that regardless of how the asset underperforms, the initial principal that the holder invested will not be affected. On the flip side, what you gain by decreasing your risk, you lose by deceasing your payout, as these notes are usually paired with a capped maximum.
Example
First, let’s say a bank issues a structured note with no interest rate. Instead, the note’s return is based on the performance of the S&P 500. By linking the return to the S&P 500 the bank has created a derivative. It has not directly invested in any related stocks. The note’s value derives from the value of the stock market. In one year the note matures and the S&P 500 has increased 10%. In this case the bank would return the full principal (based on the bond component of the note) and would issue a 10% return (based on the derivative component of the note).
Now let’s say a bank issues a structured note with a 2% fixed interest rate and a 10-year maturity. The note also has an option for early redemption if 10-year Treasury bonds interest rates exceed 2.25%. In this case, the bank would return the full principal plus a 2% interest rate when the note matures (based on the bond component of the note). However the holder could get money out of the note early if Treasury bonds become a better investment (based on the derivative component of the note).
Who gets what?
The issuer’s take is mostly in fees. At the inception of the note, the issuer already knows excatly how much they will make.
The client’s take will follow one of the scenarios that the note’s conditions lay out. Which senario it will be, will be found when the note matures (or if called early). Therefore, the client’s take is dependent on the market.