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Under the Hood: A Multi-Part Series on How Structured Notes Work

In this multi-part series, we'll dive under the hood of structured notes to help investors better understand this type of investment. For this post, we explore Uncapped Growth Notes with hard and soft principal protection.


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At Halo, we often say structured notes is one of the largest markets that many financial advisors don’t know about, particularly in the U.S.

Structured notes can be a powerful strategy for adding downside protection, enhancing income or participating in market returns. This is important, particularly in today’s environment when financial advisors and their clients are faced with continued uncertainty when investing.

On the outside, a structured note is simply a wrapper, an investment vehicle. Inside the wrapper is a combination of a zero-coupon bond and options.

In this multi-part series, we'll dive Under the Hood of structured notes to help investors better understand this type of investment. We’ll cover how client capital is being invested, and also provide some insight on how volatility impacts the pricing of certain types of structured notes.


Part I: Uncapped Growth Notes With Hard Principal Protection

There are two main types of protection when considering any structured note - hard and soft principal protection. See our more detailed post on protection types included here.

Let’s start with a hypothetical example using hard principal protection for an uncapped growth note.

Hypothetical Example

Consider the following structured note investment:

  • Underlying Exposure: S&P 500 Index
  • Term: 5 Years
  • Downside Hard Principal Protection: 20%
  • Upside Performance Participation Rate: 85% Uncapped

This structured note is based on the price performance of the S&P 500 Index (SPX). It has 20% Hard Protection on the downside. This means SPX would have to decline more than 20% on the maturity date for the investor to start experiencing losses (subject to credit risk). Essentially, the note holder is not exposed to the first 20% of losses. If the SPX is down 25% on the maturity date, the invested capital would only be exposed to a 5% loss.

So, what is the trade off?

In this case, the upside is less than 1:1 and the investor participates in 85% of the positive performance of SPX, with no cap on potential gains. For example, if SPX is up 100% in five years, the return of the structured note investment on the maturity date would be 85%.

Below is a visual payoff chart that shows the potential payoff of this hypothetical note across four broad market scenarios.


Under-the-Hood-Return-Scenario

It is important to remember that when purchasing a structured note, the investor gives up any dividends that exist on the underlying asset exposure within the note. The dividend is factored into the options pricing, which ultimately determines the upside performance participation rate. Additionally, the investor takes on the credit risk of the structured note issuer because the payoff on the maturity date always depends on that issuer’s ability to pay.

Although in this example the investor doesn’t participate in 100% of the upside performance of SPX (if one owned SPX outright) is due to the cost of having hard protection on the downside. Specifically, the more downside protection built into a structured note, the less upside potential an investor will have. To better understand this, let’s break down a structured note into its core components, a zero-coupon bond and options package.


Zero-Coupon Bond is Core to Structured Notes

As mentioned previously, a structured note is a wrapper consisting of a zero-coupon bond and options.

The principal amount is invested in a zero-coupon bond issued by the same bank that issued the structured note. This is a bond that pays back the principal plus some fixed interest rate on the maturity date. The zero-coupon bond will be exposed to the same credit risk as the issuing bank.

Like the name suggests, ‘zero-coupon’ means there are no coupons (periodic payments) except for whatever interest is accrued at the end of the period. If global interest rates are low, this amount is likely to be negligible, particularly over shorter timeframes.

To break it down further, when a structured note is issued, about 85% of invested principal goes into the zero-coupon bond, while the remainder goes towards the options package.


Options Package is Key to Payoff Structure

While the majority of a structured note consists of a zero-coupon bond, the remainder is an options package which determines the payout/participation and protection levels.

The majority of the upside performance participation (growth/capital appreciation) comes from buying call options. The downside protection comes from selling put options.

(Don’t worry, you won’t see multiple options positions listed on a client statement when investing with a structured note.)

In other words, the key features of just about any structured note comes from options. Yet, investors don’t need to be an options expert to understand the basics of how these options function within notes.

Our Structured Note Example from above:

  • Underlying Exposure: S&P 500 Index
  • Term: 5 Years
  • Downside Hard Principal Protection: 20%
  • Upside Performance Participation Rate: 85% Uncapped

For this note example, at-the-money calls are used for the upside performance participation i.e. 85% uncapped.

An at-the-money call just means the strike price is the same as the price of the S&P 500 index on the day the note is issued.

On the maturity date, any price above the strike price on the maturity date will pay off (the higher the better), and any price below the strike price means the calls will be worth nothing.

If the price of SPX on the maturity date is below the initial strike price, the at-the-money calls will expire worthless and the client will receive their initial investment back from the maturing zero-coupon bond.

Structured-Note-Options-Piece

But, why is the upside participation only 85% instead of 100% or more?

Options use leverage, so one may think there would be a lot more upside participation.

The answer is two-fold:

  1. The negligible interest earned from the zero-coupon bond (because of the current interest rate environment), and
  2. The relatively small amount of premiums received from the sales of the put options for hard protection on the downside.

The 20% downside protection is created by selling a 20% out-of-the-money put. Why? Remember that when you sell a 20% out-of-the-money put, the investor has an obligation to buy the underlying security if the security is down more than 20% on the exercise date, i.e. the maturity date of the note.

If the price of the SPX falls anywhere from 0% to -20% on the maturity date, the investor simply collects their initial investment principal back from the zero-coupon bond while the at-the-money calls expire worthless.

However, we need the premium from the puts in order to pay for the at-the-money calls and create the upside participation. The zero-coupon bond interest on its own is not nearly enough to finance the calls.

The closer the put is to the current price of the index, the higher the premium. This means the deeper the protection amount, the less premium available to purchase the at-the-money calls - the way to get upside participation.

As such, less downside protection (or more downside risk) generally means higher upside participation rates (or higher return potential).

Sometimes, the upside participation rate can be more than 100%. This is typically the case with soft principal protection.


Part II: Uncapped Growth Notes With Soft Principal Protection

For Part I, we examined an uncapped growth note with hard principal protection. For this next section, we’ll take a look at a similar uncapped growth note example, but with soft principal protection.

HYPOTHETICAL EXAMPLE

Consider the following structured note investment:

  • Underlying Exposure: S&P 500 Index
  • Term: 5 Years
  • Downside Soft Principal Protection: 20%
  • Upside Performance Participation Rate: 120% Uncapped

This structured note is based on the price performance of the S&P 500 Index (SPX). Also notice this example has 20% Soft Protection on the downside. This means the structured note holder would not be exposed to the first 20% of losses but would be fully exposed to any losses past the 20% protection level. So, if SPX is down -25% on the maturity date, the invested capital would be exposed to the full -25% loss.

In contrast, with a 20% Hard Protection, the investor would only be exposed to a -5% loss on invested capital if the SPX was down -25% on the maturity date. Performance terms, including downside protection, only matter at maturity rather than over the life of the note.

So, what is the trade off?

With Soft Principal Protection, there is a risk of being fully exposed to the loss of SPX if the price is below the protection level on the maturity date. In exchange for that risk, the upside performance is 120% of the price performance of SPX, with no cap on potential gains. For example, if SPX is up +100% in five years, the return of the structured note investment on the maturity date would be +120%.

Below is a visual payoff chart that shows the potential payoff of this hypothetical structured note across four broad market scenarios.


Uncapped-Growth-Soft-Returns

SMALL CHANGE IN OPTIONS FOR SOFT PROTECTION

Like the Part I example above, the core piece of the structured note is a zero-coupon bond. This is consistent across structured note types, and both hard or soft protection.

In addition to the zero-coupon bond, the options package determines the payout/participation and the soft protection in this example.

The majority of the upside performance participation (growth/capital appreciation) comes from buying call options. The soft downside protection comes from buying a knock-in put. A knock-in put is an over-the-counter option type that only triggers if an underlying asset falls below a certain (protection) level at maturity.

Our Structured Note Example from above:

  • Underlying Exposure: S&P 500 Index
  • Term: 5 Years
  • Downside Soft Principal Protection: 20%
  • Upside Performance Participation Rate: 120% Uncapped

For this note example, at-the-money calls are used for the upside performance participation, which is 120% uncapped. An at-the-money call just means the strike price is the same as the price of the S&P 500 index on the day the note is issued.

On the maturity date, any price above the strike price will pay off (the higher the better), and any price below the strike price means the calls will be worth nothing.

If the price of SPX on the maturity date is below the initial strike price, the at-the-money calls will expire worthless and the client will receive their initial investment back from the maturing zero-coupon bond.

Uncapped-Growth-Soft-Components

Participation above 100%, less conservative protection

As mentioned above, the participation rate of 120% for this note is much higher than the 85% participation rate for the uncapped growth note with hard protection from Part I. Let’s look at how the soft principal protection is constructed in order to understand the difference.

The benefit of using soft protection is that it provides a level of downside protection to the SPX at maturity. Soft protection is “less expensive” than hard protection because after its “protection amount”, investors are fully exposed to the loss of the SPX.

Like hard protection, soft protection is also implemented by using put options. However, in the case of soft protection, the put options are special options known as “knock-in” puts. The puts “knock-in” full downside losses when the strike price is breached at maturity, rather than beginning to take losses below the strike price.

Because the “knock-in” put is riskier, more premium is collected for selling this type of put option rather than a vanilla put option. That extra premium allows the issuer to buy more calls on the underlying index within the structured note. This gives the investor a higher performance participation rate even though the protection level (20% downside protection) remains the same.

In our example above, the “knock-in” puts will not be triggered if SPX is down less than 20% on the maturity date. However, if SPX is down 25% on the maturity date, these puts will be “knock-in” the full 25%, meaning that the entire amount the index is down will be taken out of the initial capital invested in the note.

Said another way, if on the maturity date, SPX is down -19%, the investor will receive their initial investment principle back subject to issuer credit risk. Conversely, if on the maturity date, SPX is down -25%, the investor will be fully exposed to a -25% loss on invested capital due to the puts being triggered.

We hope this dive ‘under the hood’ was helpful in understanding the components of Uncapped Growth Notes. If you have any questions or would like to discuss further, please feel free to reach out!


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