Why Structured Notes Are So Innovative – Examples Included

How Structured Notes Affect Investor’s Risk Profile

One of the golden rules in finance is that the reward you can expect from a given investment is in line with the risk you take on. A bond offers a lower reward but also lower risk of losing your money, while a growth stock offers the chance for great long-term returns but also a higher risk of losing money. Much of the investing community spends its time trying to find advantageous risk/reward opportunities, so as to find opportunities that fit their appetite for appropriate risk. 

Structured notes are an investment product that allow investors another kind of opportunity on the risk reward spectrum. Through a hybrid stock/bond approach, structured notes offer investors a way to participate in the potential upside that comes from stock ownership, but also a degree of downside protection in case the stock underperforms and the risks bear out. In other words, less risk while still having the chance at meaningful returns. It’s not magic or a trick, and there are trade-offs as compared to just owning stocks or bonds, but the hybrid nature may make it an interesting alternative for your portfolio.

What is a Structured Note?

Structured notes are hybrid securities that act like something in between debt and equity. On the one hand, the note pays a set coupon on a regular basis, which is bond-like, and makes up as much as 80% of the investment. On the other hand, the eventual payout of a structured note is based on the performance of an underlying asset, which is often a single stock.

How Structured Notes Work

Structured notes function as a contract whereby the buyer receives a fixed coupon as well as downside protection and payout upon maturity subject to certain criteria being met. The nature of the note can vary, with some focused on income generation with downside protection at the expense of upside opportunity, while others are geared more towards the upside, while still having some protection. But in each case, the focus is on a mix of fixed income coupons and payout related to performance of the underlying asset.

Here’s a structured note example: one might buy a five-year old bond tied to Microsoft at $300/share with 20% downside protection and a 4% quarterly coupon (16% annualized). This would pay back 4% of the investment each quarter that Microsoft’s price finishes above $240/share (20% below the $300 starting point). If Microsoft was below that price at the end of a given quarter, there would be no coupon. Then at the end of the five-year bond, if Microsoft was over $240/share the investor would receive the full principal back as well. Given Microsoft has only had one 20%+ drawdown in the last five years, this hypothetical note would be a reasonably safe proposition even for someone who viewed Microsoft’s shares as quite expensive.

How are structured notes created

Structured notes are often issued by leading investment banks – the Goldman Sachs or Morgan Stanley’s of the world. They create a note and then build options positions on their end to represent the underlying income. 

It’s true that investors could mimic structured notes on their own through taking similar options positions, but that would require the investor to understand options trading well, and to be able to take the time to set up such positions. Structured notes offer a time-saving, professional alternative.

In any case, structured notes always contain certain components, including:

Underlying asset/equity component

A structured note is tied to an asset and its performance. This is often a single stock, though it could also be a stock index or other investment vehicle.

In our example, Microsoft’s stock was the underlying asset, with its performance dictating the structured note’s payout.

Coupon or bond component

This is the main hybrid aspect of the note. The bond component is the quarterly coupon. Coupon payment of course depends on the performance of the underlying asset, but they come in a blend of the bond and derivative components.

Period of time (maturity)

The maturity of a given note is how long the contract runs before final observation and payout. In our case it was a five-year note, so the maturity would come at the end of those five years.

Protection

Protection is often the most important aspect of a structured note, as it serves to give the investor some peace of mind even if the underlying stock struggles. 

We’ll use the Microsoft note again as an example. Imagine a scenario where another major sell-off happens, akin to the March 2020 pandemic sell-off, and Microsoft’s stock stays below the 20% mark for two quarters, then climbs above it but stagnates for the next four and a half years, ending up at $310, or a 3.33% return over 5 years (and less than 1% annually before you count the dividend). 

In that hypothetical, the note would not pay a coupon for the first two quarters, but would then pay for the next 18 quarters, and the note holder would receive the principal back. This would lead to a 72% return even in a scenario where the stock remains flat.

That underlying performance may not be realistic, or perhaps the coupon is larger than it would be given how steady Microsoft has been this millennium, but you can change the numbers at the margins and still find the value in a structured note. 

If the stock finishes at higher than $540, the noteholder misses out on the upside in our hypothetical, and is capped at 80%. Some notes are designed for that variable, derivative component to capture some upside, but there will be a trade-off in any case. The benefit is having a more predictable, less volatile instrument that still has upside exposure.

Conclusion:

Everything in investing comes back to risk/reward. Structured notes are an innovative way of repackaging that risk and reward, and can be useful to investors who have concerns about current market valuations, need more downside protection, or want exposure to certain stocks without being locked into the current stock price. If any of that resonates with you, check out Yieldstreet’s structured notes page as well as articles and presentations to get more details.

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