Structured Notes

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.

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 risk. 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 market, 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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This has been a guide to what is Structured Notes and its definition. Here we discuss a few examples of structured notes along with advantages and disadvantages. You can learn more about financing from the following articles –

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