Structured notes are one of the latest innovations in finance. They offer a new spin on the traditional risk/reward equation for stocks and bonds by providing the potential upside that comes from equity in a structure closer to a bond. For those unfamiliar, this previous article provides a more detailed definition of a structured note.
If you’re familiar with the concept, your next step might be to ask: Are structured notes a good fit for my portfolio? Like any financial instrument, structured notes come with pros and cons, and it’s worth sorting them out to see whether they can be suitable fit for you. Let’s start with some of the benefits.
Structured notes are created to offer different types of payouts. Investors can choose from notes that focus more on downside protection and income generation (known as income notes), or more on the upside that comes from increasing equity valuations (known as growth notes). There’s flexibility in the class, income notes offer fixed income coupons that resemble bonds, and growth notes can offer a mix of fixed income coupons and upside optionality that resembles stocks, which is what makes this a hybrid offering which has its own unique set of risks and considerations in the financial world.
Structured notes are hybrid vehicles, as mentioned, but they offer exposure to an underlying asset. For example, they are often pegged to a single stock’s performance, with the long-term payout depending on how the stock does. Structured notes can also be tied to index performance, a commodity, or other underlying assets, and can offer exposure to numerous parts of the market.
One potential advantage of having the indirect exposure of a structured note instead of directly investing in the underlying asset is that structured notes may have more solid returns. An income note with downside protection, for example, the investor has the potential to gain their principal back as well as some income even if the underlying asset goes down by, say, 15% (depending on how much downside is protected). This can be a way to invest in a blue-chip stock that an investor feels may just be too highly valued to own directly, as one scenario.
A last potential Pro of structured notes is they can save the investor time. Investors might be able to construct a diversified, hedged portfolio using options, equity and bond positions that can mimic a lot of what a structured note portfolio offers. Constructing a portfolio can require a lot of time and a lot of expertise, however, whereas a structured note packages that at once, and a portfolio of structured notes can offer wider diversity.
That said, there are trade-offs to structured notes as there is to everything in investing. Here are a few of the potential cons.
Structured notes are a relatively newer financial product in the market and are not as widely traded as stocks, bonds or ETFs. Holding the note usually requires waiting until maturity to receive a return on principal and the final pay-out, as there isn’t a very active market for these notes. This can be a problem when combined with the next issue.
Pricing on the structured notes is often rigidly calculated by a matrix, with coupon payouts and final payout based on the price at the day of observation. If the underlying asset is volatile or if it trades sporadically around those days, the investor could be at risk of missing out on coupon payouts or the final payouts.
For example, an income note tied to Procter Gamble could have a five-year maturity, and if Procter Gamble trades above the minimum threshold for a payout for 4 years and 11 months, the investor could receive all their coupon payments. But if something happens either at Procter Gamble specifically or market-wide, like a March 2020 environment, and the stock sells off to below the protected downside threshold, the investor can lose the final payout and potentially some of their initial investment. Given there isn’t a liquid market to sell the structured note early and ‘lock in’ return of principal, this is another potential risk.
The flipside of this is that some structured notes have a call option built-in for the issuer, where the issuer can buy the notes back after a certain time (but before maturity) for a certain price. If an income note is called, full principal is returned to the investor plus all previously earned coupons, not a bad outcome, however, then the investor is faced with the burden of reinvesting their capital which increases market timing risk.
The last thing to watch for is that structured notes come with higher fees than stocks, bonds, or ETFs, as there is more that goes into their creation and maintenance. This is a trade-off for the time-savings mentioned above.
Almost by rule, there are no perfect investments available – if there were, everyone would buy them. Structured notes are no different: they repackage risk/reward in a different, hybrid format, and offer characteristics of both bonds and equities, but they come with both pros and cons.
At the same time structured notes can play a pivotal role in diversifying your investment portfolio. They provide a unique blend of fixed income, equities, and derivatives. This financial instrument can introduce elements of protection and customization that are otherwise challenging to achieve in traditional securities.
In the current market environment of high volatility, stretched valuations and low interest rates making bonds nearly un-investable, structured notes may potentially offer an interesting middle ground, with some downside protection, income, and the in the case of growth notes a chance to earn upside if the value of the underlying equity moves in an upward direction. As a diversifying agent of one’s portfolio, structured notes can be a useful addition. And if you’re looking for the next step, a portfolio of income notes can potentially spread out the risk and variety of incomes from individual notes and may simplify your investment process. Yieldstreet has the ability to offer this type of portfolio, and it may be worth your consideration if you’re looking for something new in your investing.
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