What You Should Know About Risks When Investing in Structured Notes
The broader financial markets in 2021 offer challenges for investors looking to protect and grow their capital and maintain a diverse portfolio. Equity markets seem to have rallied faster than the economy has recovered from the COVID-19 pandemic. Bond markets offer minimal interest rates and outsized risks of inflation and rising rates. Classic 60/40 portfolios or certain other forms of asset allocation may not be good enough in this climate.
Structured notes are a newer product that may fill this gap for investors. A structured note, specifically income focused structured notes offers a hybrid security that investors can potentially use to maintain diversification, and earn income while benefiting from a level of downside protection.. But, as with any financial product, structured notes need to be fully vetted by investors both for the risks associated with them and to see if they fit with the investment objectives for one’s portfolio. As you consider new markets and opportunities, here are a few risks associated with structured notes to keep in mind.
First: Defining Structured Notes
Structured notes were created by investment banks to offer their clients a product that acts like a mix of a stock and a bond. In the instance of an income structured note, the investor holds the note, which often pays them a quarterly coupon over the duration of the note as well as their principal back at the end of the note. Those payouts depend on the performance of the underlying asset – usually a single stock – and whether it stays above the downside protection threshold. The investment bank creates this through owning the stock and a variety of options positions around the stock.
This becomes a hybrid security for the investor, one that offers both a bond component with protected downside and regular coupon payments, and in the case of a growth note, a derivative component that gives the investor a chance at upside return. Growth notes typically offer a lower coupon but potential upside if the underlying stock increases in value, all while providing potential downside protection from the bond aspect of the note in the scenario that the price of the underlying stock decreases.
Structured Notes Risks
Market risk
There remains market exposure to the underlying asset. That asset is often a single stock, though it could be an index or a futures contract or other instrument. Each structured note is unique, and while many of them come with downside protection, that is often only up to a certain point, like 15 or 20% downside. That means if the asset trades below those levels, income noteholders may miss out on payments or even on the full return of their principal.
Stock Market Risk / Timing Risk
A more general but painful version of that risk is general market risk. Structured notes make payments based on the underlying asset price on given observation dates. If the stock, for example, is above the minimum price on the observation date, the investor receives a coupon or their full principal back (if it’s the final maturity date for the note). Structured notes are not traded very frequently, so investors are usually locked into the position until maturity. It’s easy to imagine a structured note with even the biggest blue-chip name as an underlying asset, but that had a maturity date of March 15, 2020 – days before the world reacted to the Coronavirus pandemic. Given the market sell-off that the indices rebounded from by June, our hypothetical structured noteholder would have missed out solely due to bad market timing.
Credit Risk
Investment banks sell structured notes, and they ultimately have to pay back the returns to investors. An insolvent bank might not be able to make payments like this. It’s important for investors to ensure they are buying notes from banks with good balance sheets and reputations to help protect against the impact of any extreme events at the bank.
Miss out on potential upside
Risks in the market also come from moves we don’t make, and structured notes include those risks as well. If an investor buys an income note with Amazon as the underlying asset,, it’s possible the investor could do worse than just owning Amazon shares if the coupon rate is less than the growth achieved by Amazon over the investment period. The reality of income notes is that the investor is giving up something on the potential upside – and paying a fee to do so – for the security of having downside protection. This is a core feature, but it’s worth remembering before owning an income note.
Misunderstood Product
Structured notes are a newer product, and they’re more complicated than traditional investments in stocks or bonds. Each structured note comes with different aims and terms as well. So, the investor interested in these products needs to first be aware that they are holding a more complicated instrument, where small changes in the underlying asset’s price may lead to radically different outcomes. That investor also needs to check the terms of the note closely to make sure they understand what they are exposed to, what risks there are, and how their note will perform in a variety of scenarios.
A unique product with a different set of risks
Growth structured notes offer something different to investors. Instead of holding a bond that will have a capped upside and, in this market, either outsized risks or minimal coupon payments; or investing in a stock which might be more than fully valued and which can fluctuate or drop for a number of reasons, investors can select growth structured notes as a hybrid fit, one that offers the potential for downside protection, regular payments, and upside exposure.
That doesn’t mean growth notes are right for everyone, or that they should take up all or even an outsized part of one’s portfolio. There are several risks that come with structured notes, some that are unique to the instrument and some that are general market risks that these notes can’t totally protect from. Every investment product offers a trade-off of risks and rewards, it’s just that structured notes, being a newer type of product, require more time up front to understand the upsides and downsides.
Income structured notes can play an important role in a diverse portfolio in filling a gap on income generation and growth notes, while generating a lower level of income they don’t give away too much upside opportunity. One way Yieldstreet approaches these challenges is creating a portfolio of income structured notes, so single stock risk and other factors are minimized. If you’re interested in learning more about this asset class or how to invest in it, check out our structured notes offering.
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