A structured note is a debt instrument built with contractual elements based on the performance of underlying assets, such as indexes or individual securities. The contractual features and how they are structured within the note allow portfolio managers and investment advisors to customize each note’s purpose and risk-reward profile as needed.
There are three main investment functions of a structured note. First, it acts as a replacement for a direct equity investment, offering the potential upside of equity exposure while protecting against downside risks when held to maturity. Second, structured notes offer the potential for yield enhancement by converting equity volatility into coupon payments. Third, structured notes can be used to potentially deliver enhanced returns, whether in a single-stock, particular sector, or index, when held to maturity.
The price of a structured note is based on your client’s risk tolerance, return objectives, and the holding period or term. What really sets these investments apart is the level of customization; portfolio managers and investment advisors can choose how the underlying assets within the note are structured, customizing the level of risk, reward, and term.
For instance, with interest rates continuing to rise, a note designed for full downside protection could be tied to the performance of the S&P 500 and have a three-year duration. On the upside, investors can receive “point-to-point” leveraged performance of the S&P over those three years, paid at maturity and capped at a maximum return of 21%, indicatively. By forfeiting greater potential upside gains and dividend payments on the underlying index, the investor receives significant downside protection – up to 100%, in fact.
In this example, regardless of if the S&P 500 is down 10% or 50%, the client will still receive their entire principal back at maturity. With current market volatility and many economists and policymakers bracing for a recession, there may be a greater appeal for downside protection.
