What are Structured Notes?
A structured note can be considered as one type of debt security wherein the return is linked to the performance of one or more underlying assets (interest rate, commodity prices) or index such as equity index, sector-based equity basket, etc.
Examples of Structured Notes
Below are a few examples of structured notes.
- One Year Bond with a Call Option on Copper
- Three Year Bond with a Futures Contract on Crude Oil
- Two Year Bond with a Put Option on An Index
- 3 Month Bond with a Forward on Currencies
- 1 Year Bond with an Interest Rate Swap
Advantages of Structured Notes
Given below are a few examples of how structured notes benefits investors.
- Accessibility: Investment banks create and then sell these products that allow one to have access to asset classes that are available only to certain investors, which may be difficult for the common investor to access. By participating in such products, the investors will gain access to investing in a wide range of asset classesAsset ClassesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more, which otherwise would not have been possible had it.
- Diversification: It helps investors achieve the motive of diversification by not having to put all eggs in one basket. By gaining access to a wide range of asset classes, an investor tends to gain the benefit of diversification by spreading the risk along with different assets.
- Customization: Structured notes can tend to have customized pay-outs and also the exposures. Some notes will tend to have a return with little or even no investment risksInvestment RisksInvestment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more, whereas, at the same time, there will be other notes that offer high returns without any sort of principal protection—hence based on the risk appetiteBased On The Risk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more and fanciness of the investor, he/she may choose to get into derivative contracts through such structured notes, that tend to align with any particular market or even economic forecast.
- Flexibility: A note can be created by mixing a bond with a derivative relating to any market in any combination, and this gives scope for flexibility as per the risk-return profile of the investor.
- Tax efficiency: Usually, the returns arising out of a structured note is often considered as long term capital gain. Some countries and jurisdictions have certain rules and provisions in place, which point out that certain capital gains will not be taxable in the hands of the investors. Hence such structured notes tend to gain the benefit of having to gain in the form of tax efficiency.
- Leveraged returns: Another benefit that an investor in such structured notes seeks to get is the returns through inherent leverage that allows the derivatives return to be higher than the underlying asset.
Disadvantages of Structured Notes
The points highlighted below to elucidate the disadvantages of these structured notes.
- Credit Risk: It is no doubt that a structured note is often purchased to be held until the maturity of the bond. However, like any other debt instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more, it bears the possibility that the issuer may go forfeit on its obligation. Hence there arises a significant amount of credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more. The issuer may fail to make all payments on its obligation. Hence the investor would certainly be exposed to a great amount of credit risk prevalent in the particular structured note.
- Lack of Sufficient Liquidity: Structured notes do not trade in the secondary marketSecondary MarketA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets.read more, unlike the equity or any embedded derivative instrument attached to that. Should an investor have an urgent requirement for liquidity and needs the money, he would have no other option than having to sell the security to the original issuer. The original issuer, however, knowing that the investor is bound by the contract, may take advantage of the situation and may not offer a good price or money, assuming that they are certainly willing to make a good deal out of the same.
- Pricing being Inaccurate: More often than not, it is often noted that the structured notes do not tend to be traded in the market post their issuance. The prices of such products often tend to be calculated by a certain matrix, which is usually different than the net asset value. The matrix pricing is based on a comparative approach to a value such assets, and hence it is the bias of the original issuer that comes into play, and hence the pricing may at times be inaccurate or even biased to a certain extent.
- Possibility of Huge Loss: Similar to how leverage tends to magnify returns, it tends to be a double-edged sword. The derivative returns may also go down south and may badly lead to significant losses for the investor. Hence careful scrutiny and due diligence are required on the part of the investor.
Conclusion
Structured note being a well-structured financial product, tend to give investors the benefit similar to ‘killing two birds with a single stone’ as they tend to get exposure to different products using a single product. They will now gain access to markets that were earlier restricted to only a few well-sophisticated investors, and the common investor would not be able to gain such access.
Moreover, such products offer a great amount of customization and flexibility as the investor can choose to get into a derivative product that he is well aware of after studying the risk-return characteristics, thereby making the right choice after considering his goals and objectives.
Although such structured notes do give the investor the benefit of having to gain through leveraged returns through exposure on derivative products, there are possibilities that the underlying may perform badly, and the investor may experience a significant loss in this regard.
There is, of course, the exposure to significant credit risk if the issuer defaults. Hence it becomes utmost important that one carries out thorough due diligence and ensures one has a proper understanding of such products before venturing out to invest in them.
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