Structured Notes

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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. They are sold by banks, corporate borrowers, and financial institutions.

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Structured notes investments allow more flexibility than most investment options and provide a wider range of potential payoffs which might be difficult to find in another asset class. However, it remains a complicated asset class with significant downsides such as default risks, market risks, and low liquidity. Therefore, this form of investment has not been very popular with the masses.

Key Takeaways

  • A structured note is a type of financial product whose return is linked to the performance of one or more underlying assets (such as interest rates or commodity prices) or indexes (including equity indices and sector-based stock baskets). 
  • It allows investors to be exposed to derivative instruments that offer amplified returns. 
  • There is an inherent exposure to heightened credit risk in the event of an issuer default. Consequently, conducting thorough due diligence is essential, ensuring a comprehensive understanding of these factors before making any investment decisions.

Structured Notes Explained

Structured notes are debt obligations with a combination of derivatives in the process. The derivatives aspect brings in the changes in the value of the underlying asset.

Structured notes pricing, a well-structured financial product, tends 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 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 to 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 of utmost importance 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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Types

There are different types of structured notes investments depending on the underlying asset, risk appetite, and other related factors. Let us understand the types to fully understand the concept.

  • Equity-Linked Note: A single share of a company or an index can determine the rate of return of the contract.
  • Interest Rate-Linked Note: The rate of return might be linked to the interest rate of a party relevant to the contract.
  • Commodity-Linked Note: Commodity stocks or an index such as food processing or energy or automobiles might be linked to the returns.
  • Credit-Linked Note: A change in the credit, both positive or negative such as the changes in risk level, loan default, or even the shift in the value of the collateral can be linked.
  • Market-Linked Note: The performance of bonds, a basket of shares, or derivatives might be linked to the rate of returns.
  • Currency-Linked Notes: The pairing of two currencies and the movement in each of their market value might be linked to the rate of return.

Examples

Let us understand the concept of structured note pricing with the help of a few examples. These examples will give us a practical understanding of the concept and its related factors.

  • 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

Risks

Like any other asset class, structured notes investments are also not free of risks. Let us understand them to fully understand the concept and its implications through the explanation below.

  • Market Risk: In comparison to other asset classes that are easy to sell in the secondary market, this investment might be difficult to sell at a desired price as the price of the contract in the secondary market might be subject to interest rates, economic conditions, and other such factors.
  • Credit Risk: If the investor is unable to pay the amount upon maturity or a date thereafter, it becomes difficult for the lender as the investors and not have recourse for the underlying asset. Therefore, investors might not get any returns on their investments.
  • Volatility Risk: The movements of the market are beyond anyone’s control and a decline in the interest rate or the market performance can have a significant impact on the returns of the investor.
  • Liquidity Risk: In comparison to other assets that can be sold easily on the secondary market such as stocks or bonds, this asset class is considerably more difficult to sell at a desirable price as there are multiple underlying factors.
  • Foreign Exchange Risk: If the contract is entered into in a foreign country, the movement in either of the currency could significantly affect the returns of either party.

Pros and Cons

Let us understand the pros and cons of structured notes pricing and other related factors through the discussion below.

Pros

Cons

The points highlighted below to elucidate the cons of this asset class.

Frequently Asked Questions (FAQs)

1. Are structured notes a good investment? 

Structured notes can offer potential benefits like tailored risk exposure and enhanced returns. However, they often involve complex payoffs linked to underlying assets, which may not suit all investors. Understanding the terms, risks, and costs before investing and seeking advice based on your financial goals and risk tolerance is crucial.

2. What is the commission on structured notes?

Structured notes may have embedded fees and costs, which can include issuance and administrative fees. These costs vary by issuer and type of note. It’s advisable to carefully review the offering documents and consult your financial advisor to understand the commission or fees associated with a specific structured note.

3. Do structured notes trade on an exchange? 

Structured notes are primarily sold over-the-counter (OTC) through financial institutions, meaning they’re not traded on traditional exchanges like stocks. Their secondary market liquidity can vary, potentially impacting the ease of selling before maturity. The lack of exchange trading may affect pricing and availability.

This has been a guide to what are Structured Notes. Here we explain its examples, risks, pros and cons, and its types in detail. You can learn more about financing from the following articles –

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