Risks of Structured Notes: What Investors Need To Know

Are structured notes a good investment? This question often perplexes investors seeking to diversify their portfolios. Structured notes, complex financial instruments that combine bonds with derivative components, have gained popularity in recent years. However, their intricate nature and potential risks warrant careful consideration.

Understanding Structured Notes

Structured notes are complex financial instruments that combine elements of bonds and derivatives to offer investors unique investment opportunities. These hybrid securities are designed to meet specific investment objectives, such as growth, income, or risk management. Structured notes are issued by banks and provide investors with exposure to various underlying assets, including stocks, indices, commodities, or currencies.

Types of Structured Notes

1. Income Notes: These focus on generating regular income through periodic coupon payments. They often provide downside protection and can be used for tactical investments on both ETFs and stocks.
2. Growth Notes: Also known as Participation Notes or Tracker Notes, these allow investors to participate in the upside performance of an underlying asset. They can offer greater than 100% upside participation in some cases.
3. Absolute Notes: Sometimes called Dual Directional or Absolute Performance Notes, these enable investors to benefit from both positive and limited negative performance of the underlying asset.
4. Digital Notes: Similar to Income Notes, but they pay a single coupon at maturity instead of fixed intervals.
5. Principal Protected Notes (PPNs): These offer full principal protection from market-related losses while providing a market-linked return.

How Structured Notes Work

Structured notes typically consist of four main components:

1. Underlier: The reference asset or index to which the note’s performance is linked.
2. Maturity: The predetermined time frame for the investment.
3. Expected payoff at maturity: The potential return based on the underlier’s performance.
4. Protection: Various types of buffers against price declines in the underlier.

The performance of structured notes is linked to the underlying asset or index through a predetermined formula. This formula determines the payout structure, which can include features like downside protection, upside caps, or enhanced returns.

Potential Benefits

1. Downside Protection: Many structured notes offer a level of protection against market declines, which can help manage risk in volatile markets.
2. Customized Exposure: Investors can gain access to specific market segments or strategies that might otherwise be unavailable to retail investors.
3. Income Generation: Some structured notes provide the potential for regular income payments, which can be attractive in low-yield environments.
4. Diversification: Structured notes can offer exposure to various asset classes, helping investors diversify their portfolios.
5. Tailored Risk-Reward Profiles: These instruments can be designed to work in different market environments, providing a clear path to risk reduction or potential outperformance.

Key Risks of Structured Notes

Structured notes, while offering unique investment opportunities, come with several significant risks that investors need to understand. These complex financial instruments combine elements of bonds and derivatives, which can lead to various challenges for investors.

Credit Risk

One of the primary concerns with structured notes is credit risk. The principal protection and potential returns are only as reliable as the financial strength of the issuer. If the issuing company faces bankruptcy or financial distress, investors may lose some or all of their investment. In such scenarios, structured note holders are typically considered unsecured creditors, which means they might recover little, if any, of their original investment.

Market Risk

Market risk is another crucial factor to consider when investing in structured notes. The derivative portion of these notes is exposed to the performance of the underlying asset or index. This exposure can lead to:

1. Underperformance: Structured notes may earn no return for the entire term, even if held to maturity.
2. Limited upside: Some notes might not provide full exposure to their reference asset(s), potentially causing investors to miss out on significant gains.
3. Principal loss: Depending on the note’s structure, investors may lose some or all of their principal if the underlying market performs poorly.

Liquidity Risk

Liquidity risk is a significant concern for structured note investors. These products are primarily designed as buy-and-hold investments, often with long maturities. Key liquidity issues include:

1. Limited secondary market: Structured notes are generally not listed on exchanges, and there’s no guarantee of a secondary market for trading them.
2. Locked-up capital: Investors may have their money tied up for the entire term of the note, which can extend to 10 years or more.
3. Call provisions: Some notes include call provisions that allow issuers to recall the note before maturity, potentially leading to unexpected loss of investment or returns.

Complexity Risk

The complexity of structured notes poses another risk for investors. These products can be difficult to understand and evaluate due to their intricate structures and terms. This complexity can lead to:

1. Mispricing: Complex instruments may trade infrequently, making price discovery difficult or impossible.
2. Hidden costs: Structured notes often have higher fees than traditional investments, which can be challenging to identify and understand.
3. Misaligned expectations: Investors may not fully grasp the potential outcomes or risks associated with the product, leading to unexpected results.

Performance and Cost Considerations

Historical Performance

Structured notes have gained popularity in recent years, particularly during periods of market volatility and low interest rates. They are often marketed as a way for risk-averse investors to capture additional income while limiting downside volatility. However, academic research has shown mixed results regarding their performance. Some studies have found that structured notes, on average, have failed to outperform a balanced portfolio of stocks and bonds. In some cases, they have even underperformed risk-free Treasury bills.

Fee Structure

Investors should be aware of the significant costs associated with structured notes. While these fees are not paid directly, they are built into the principal value as a markup or embedded fee. On average, the markup or embedded fee is around 2.9%, based on a sample group of notes issued in early 2020. This means that the fair value of the notes is typically about 97.1% of the purchase price.

Brokers selling structured notes receive commissions averaging about 2% from the issuing bank. Some notes, such as the Barclays contingent coupon notes, have even steeper fee structures, with markups as high as 4.59%. This can translate to an effective expense ratio of 2.3% per year for a two-year note, which is considerably higher than many traditional investment products.

Tax Implications

The tax treatment of structured notes can be complex and may vary depending on the specific structure of the note. Generally, structured notes are considered debt instruments, and gains are taxed at ordinary income rates rather than the lower capital gains rate. This holds true even when notes are sold before maturity.

1. Principal-protected notes: These typically receive a Form 1099-OID (Original Issue Discount) in non-qualified, taxable accounts. Investors may accrue “phantom income,” which is taxable even though it has not been received.
2. Notes with principal at risk: While OID tax reporting typically does not apply, the IRS has not provided clear guidance on the tax treatment of these notes. Issuers often characterize gains or losses as long-term capital gains or losses if held for more than a year.
3. Yield notes: These are often characterized as having two components: a non-contingent interest-bearing debt instrument and a put option. Periodic payments may be allocated between interest income and put premium.

Investors should carefully consider these performance, cost, and tax implications when evaluating structured notes as part of their investment strategy. Consulting with a financial advisor can help in analyzing these complex products in the context of an individual’s financial situation.

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Conclusion

Structured notes present a complex investment landscape with both potential benefits and significant risks. Their ability to offer customized exposure and downside protection can be appealing, but investors must carefully weigh these advantages against the inherent credit, market, liquidity, and complexity risks. The intricate fee structures and tax implications further underscore the importance of thorough research and professional guidance to analyze whether structured notes align with individual financial goals and risk tolerance.

Ultimately, the decision to invest in structured notes requires a deep understanding of their mechanics and a clear assessment of one’s investment objectives. While these products can offer unique opportunities, they may not be suitable for all investors. Want to see if structured notes fit in your retirement plan? Schedule a free consultation over the phone, via Zoom, or in one of our 3 Connecticut offices in West Hartford, Middletown, or Middlebury CT.

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