What’s Ahead:
- Structured Note Protection can potentially eliminate or reduce market losses
- The two main types of protection are discussed: soft (barrier) and hard (buffer)
- Market outlook and risk tolerance are considered for choosing one over another
Insurance against market downturns
Understandably, one of the most common questions we get pertains to the “protection” available when investing in a structured note.
Because structured notes are a market-linked product, to take advantage of market advances they are generally exposed to market retreats as well. However, a defining feature of structured notes, as opposed to conventional fixed income products, is their ability to add contractual downside protection. By modifying an asset’s potential outcomes, a note may absorb all or a portion of negative market returns. In this sense, a note can act as insurance against market downturns.
A note’s principal protection generally comes in two forms: Soft (Barrier) and Hard (Buffer). Both types absorb any losses within a protection threshold. The differences in protection occur when losses exceed the protection level.
When the Underlier Lands Within The Protection Threshold
For example, if a note has 25% protection, and the underlier it is linked to is down 20% at maturity, the note’s protection would absorb all losses and the note would return principal in full.
When the Underlier Lands Below Soft Protection
In another scenario, if an underlier is down 30% at maturity and 25% Soft protection is in force, the note would be down 1:1 with the underlier. In this second scenario, the note would be down 30% to equal the underlier.
When the Underlier Lands Below Hard Protection
Hard (Buffer) protection works a touch differently. Similar to Soft (Barrier) protection, any losses down to a buffer threshold are fully absorbed—the note’s “protection” kicks in and principal is returned. If losses exceed a buffer threshold, a note begins to recognize partial losses.
For example, if a note has 25% Hard protection, and the underlier it is linked to is down 20% at maturity, the note’s buffer would absorb all losses (similar to a Barrier note) and the note would return principal in full.
However, in another scenario, if an underlier is down 30% at maturity and 25% Hard protection is in force, the note would be down only 5%.
Investors should keep in mind a note’s protection and payoff are subject to the credit risk of the note’s issuer.
When Should I Use Soft or Hard Protection?
This begs the question: which form of protection is better? The simple answer is entirely linked to an investor’s risk tolerance.
Since Soft protection notes have more downside risk, they will have higher upside potential than Hard protection notes, all else held equal. As a general rule, conservative investors typically prefer Hard protection, as it offers more downside risk protection, while more aggressive investors may prefer Soft protection to take advantage of higher return potential.
The chart below illustrates the differences between Soft and Hard principal protection across a range of market environments.
Investors seeking to generate attractive upside or who are comfortable with added risk may consider notes with Soft protection. On the other hand, investors seeking to reduce negative returns and are willing to sacrifice upside potential may prefer notes with Hard protection.
Please see our other important disclosures.
