A growth note is a financial instrument with a payout based on the performance of an underlying equity. Growth notes pay equity upside at the end of the term of the note, up to a limit, while also capping the downside.
These notes are usually structured and issued by investment banks, and are constructed to mimic sophisticated option strategies that institutional investors tailor to specific market conditions. They work particularly well in a cycle of high market volatility, as they can help protect investors against large fluctuations.
The payout of a growth note is similar to that of a protective collar option strategy, where an investor buys the underlying stock (for example, Meta) at $100, sells a call option (pledges to sell the stock) at $130 and buys a put option (has the right to sell the stock) at $70. It can be summarized in the graph below:
Income notes are more similar to fixed income securities, as they offer a coupon based on the equity performance. While the investor is exposed to the risk of potential default, negative equity performance will not be reflected in the loss of principal.
While all structured notes specifically limit the risk of losing the principal, their limited upside can be a potential drag if the underlying instrument – the equity – posts strong growth. Indeed, the main feature of equity exposure is unlimited upside potential, and an investor buying these notes should be aware that they won’t be able to profit from that.
In a less volatile market, this strategy is also less effective as it requires a premium that would effectively go to waste. Indeed, if equity moves are subdued, there is no use for a cap even as the investor is still paying for it.
Both growth and income notes, while differing in the structure – income notes offer more downside protection but more limited upside potential – expose the investor to the potential default of the issuer.
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