Structured notes are more than an estimated $2 trillion dollar market globally. So why haven’t more investors heard of them?
Traditionally, structured notes had a $1 million minimum investment. They were only available to high-net-worth or institutional investors—but they are now becoming more accessible.
With the help of Visual Capitalist, we created the below infographic to explain what a structured note is, describing two main types and how to implement them in a portfolio.
Basics of a Structured Note
A structured note is a hybrid security, with a bond component and an embedded derivative.
Structured notes are issued by major financial institutions. Since they are the liability of the issuer, it is critical that the investor is comfortable with the issuer—as with any bond purchase.
Almost all structured notes have four basic parameters.
Maturity – The term typically falls within 3 to 5 years, can range 6 months to 20 years.
Payoff – The amount the investor receives this expected return at maturity.
Underlying asset – The note’s performance is linked to the price return (excluding dividends) of an asset - such as stocks, ETFs, indexes or foreign currencies.
Protection – The level of protection the investor receives if the underlying asset loses value.
As long as the underlying asset does not fall lower than the protection amount at maturity, the investor will receive their initial investment back in full.
This is the primary draw of structured notes: they provide a level of downside protection, while still allowing investors to participate in market upside.
Types of Structured Notes
There are a variety of structured notes, providing investors with diverse options and a range of risk/return profiles. Structured notes generally fall into one of two broad categories: growth notes and income notes.
Investors receive a percentage—referred to as the participation rate—of the underlying asset’s price appreciation.
Over an income note’s life, investors receive a fixed payment known as a coupon. Income notes do not participate in the upside returns the way a growth note does—but they may generate a higher income stream than a standard debt security or dividend-paying stock.
This is because protection is offered for both the principal and the coupon payments.
Income notes have another big advantage: their yields can spike in tumultuous markets, as was demonstrated during the market volatility near the end of 2018.
Structured notes are powerful tools that can accomplish almost any investment goal, and investors commonly use them as a core portfolio component.
Step 1: Select a portfolio asset class where downside protection is desired.
Step 2: Reallocate a portion of the asset class to a structured note
Step 3: Improve potential risk/return performance.
The asset class can demonstrate an enhanced return profile, with less downside risk.
Lowering Barriers Through Technology
Technology is becoming more ingrained in financial markets—empowering investors to access structured notes more easily through efficient automation and broad democratization.
The market is already becoming more accessible. By 31 October 2019, the average transaction size had decreased by almost $500,000 over the year prior.
Technology also offers other benefits for investors:
-Lower transaction costs
-Tailor made, customizable offerings
-Personalized portfolio risk controls
As more investors take advantage of this asset class, they may be able to improve their return potential while limiting their risk.