Why Structured Notes Are One of the Most Innovative Options to Come Out Since the Mutual Fund
What a year this has been for the markets. It was the fastest drop in the stock market—of over 30 percent—in the history of the modern stock market, even eclipsing the Great Depression. With rates at historical low levels and with the Federal Reserve and Treasury pumping cash into the system, the stock market has recovered very nicely. The Nasdaq index, specifically, has really grown this year with the “work-from-home” stocks exploding on the upside.
For years, financial advisors have talked about modern portfolio theory and the need to diversify into bonds and alternatives to help keep volatility at bay. This was a way to help keep the risk lower than what we could bare. When bonds were paying four percent or higher, this was a great way to accomplish lowering risk in the event of a stock sell off. Bonds would go up or at least maintain value. However, in the last three major sell-offs for the stock market, the bond market sold off too with cash being the chosen safety net. The Federal Reserve recently announced that they see rates staying low for years and have removed their inflation target. So, now what? Where should I put some money in these vague times?
Structured investments can help.
Structured investments are not suitable for all investors. They involve a variety of risks, and each investment will have its own unique set of risks and considerations. Before investing in any structured investment, an investor should review all applicable offering documents for a comprehensive discussion of the risks associated with the investment.
Before Structured Notes
Every year, a new type of risk mitigation option comes out, being touted as the next game-changer in the investment industry. Insurance companies, banks and investment firms come out with a new strategy and then try to package it inside of a mutual fund, ETF or annuity. As quick as these strategies come out and have a decent track record, they may fail to provide the risk mitigation needed. The yearly cost on these products can also be high. And they seem to never perform as well long-term as they are expected to. Then, they go away and the next strategy is introduced.
With passive investment options, many retail investors have decided to avoid that game and just buy passive equity ETFs or mutual funds. But when it comes to adding alternatives and fixed income into their portfolios to help lower risk, they’re stuck with cash, paying basically nothing, or bonds, paying less than two percent. The evolution of structured notes has helped allow many retail clients to have access to potentially higher income or growth which the fixed income options may not be able to provide.
What Is a Structured Note?
The shell of the structured note is a bond or debt obligation of an investment bank. They tend to have a maturity date ranging from one to seven years in length, on average. Many of the big investment banks, like JPMorgan Chase, Goldman Sachs, HSBC, Barclays and Citibank, issue them. They are meant to be a buy-and-hold position held to maturity. Like a bond, you do have default risk; if the issuer of the note files for bankruptcy, you may lose a portion or all of your principal.
However, the inner workings of structured notes are extremely different than a bond and a lot more complex.
A bond tends to have a stated interest rate or some sort of calculation on how you get paid your interest by lending the issuer your money. With a structured note, your return is normally based off of something different, called the “underlier,” like a stock index, a commodity price or maybe on a small concentration of individual stocks. As in any investment, the lower or higher the risk, the lower or higher the return is based on how the underlier performs. Volatility and interest rates are the biggest factors in determining the terms of the note. There are many kinds of structured notes, and they are extremely intricate so you should only deal with a financial advisor who is well versed. Structured notes are normally broken into three types: growth notes, income notes and callable growth notes. The following are three hypothetical examples.
The growth note concept can be straight forward. It is meant to “grow” your money. An example would be a five-year term that is based on the Dow Jones Industrial Average. The note would pay you 135 percent of whatever the index does over the next five years with no cap on your upside. If the market goes up—for example, 30 percent over the next five years, I would receive my principal back and a 40.5 percent rate of return because of the leverage used. It also has a buffer of 10 percent on it to help cushion my downside protection. Meaning, after five years, if the Dow index is down 20 percent, I would lose just 10 percent, as the first 10 percent is covered from the buffer.
Sound too good to be true? Well, not necessarily.
Keep in mind that when this matures on that exact date, if the index has gotten hammered like it did in March of this year, I could have had my money all mature with no gain or a loss. Let’s say I bought it today, and the market went up 50 percent in four years and 10 months. Then, we have a bad drop, and the market collapses down 5 percent from initial levels when I bought the note at maturity. I would walk away with just my money back and no interest on a five-year investment. One of the other negatives is I would not collect the dividends on the underlier. So, by all accounts, you want to diversify your assets into different maturity dates, different indexes and also different issuers to diversify default risk. There is no guaranteed secondary market for market-linked notes. The issuer may offer to buy them back prior to maturity, often at a discount, but they are not required to do so. In my experience, I rarely have seen them sold prior to maturity at the actual intrinsic value, meaning that holding them to maturity is normally your best outcome.
An income note can also be a simple concept. It is meant to provide you with “income” on your money. Let’s take the same term as above. It’s a five-year term based on the Dow Jones Industrial Average again. However, this one pays you a 2.5 percent coupon or interest payment every six months for an annual total of 5 percent, as long as the index isn’t down more than 20 percent since inception on each of the sixth month coupon dates. However, if on each sixth month coupon date, the index is down more than 20 percent, my coupon payment would not be received.
Keep in mind, the negative on this is even if the market is steam rolling up, my upside is capped at the coupon payment, and I do not get to participate in the gains. I also might miss out on some, or all, of my coupon payments depending on the underlier and the coupon dates. If at maturity, the index is below the buffer, I would walk away with a loss of some principal. Hence the reason for the higher coupon than traditional bonds. These notes also typically carry the same level of protection at maturity, whether that be a buffer or barrier. If the protection feature is breached at maturity, the investor would be exposed to loss of principal.
Callable Growth Notes
These can get a little more complicated. Let’s look at the same scenario where it’s a five-year term based on the performance of the Dow Jones Industrial Average. This does not pay a coupon. However, you may not need to wait the five years like a growth note. The way this one works is if we buy the note today and the index in 12 months is flat or up anything from when we bought it, we would get our principal returned and a fixed payment like 7 percent. However, if the index is down on that exact one-year anniversary, then I have to wait until year two. On the second-year anniversary date, if it is now flat or up from the inception two years earlier, then I get my money back and the 7 percent fixed payment times two, equaling 14 percent, since I was in the note for two years. And if down, then it goes to year three and so on. On year five, if the index never went up, then it will look at the net result of the index. If it was down 20 percent, as in the income note and growth note examples, I would lose 10 percent since I had that 10 percent buffer.
The downside here is my growth is capped and my principal could be locked up for five years with no fixed payment. I could also lose my principal or a big portion if the underlier does not perform. Keep in mind you still have all of those other risks mentioned about liquidity risk, maturity risk, default risk, etc.
Are Structured Notes the Missing Piece of Your Portfolio?
There is no perfect investment and I by no means think structured notes are flawless. All investments have some sort of risk, including, but not limited to, market risk, inflation risk, tax risk, interest rate risk, call risk and liquidity risk. The underlier is also a big decision in the purchase of a structured note, and I normally suggest an index and not a single stock or commodity.
In an era of low interest rates and possible inflation coming down the pike, the rate of return on most investors’ money is an important factor to consider. Structured notes are just an alternative to the regular modern portfolio theory type of asset allocation approach. Do they make sense in your current portfolio and situation? I think everyone is different and having an educated financial planner who understands these products is key. Structured notes give you another resource to help you achieve financial success. In today’s world of zero interest rates, these just might be the missing piece of your portfolio.