Although structured notes are tied to an underlying asset, they also have three other components that investors can adjust for their given investment situation. So, unlike owning a stock outright, there tends to be some level of protective cushion with structured notes.
This partial protection is based on the downward movement of the underlying stock or index. In other words, investors may tend to think that structured notes are risky because of a lack of familiarity. Structured notes can provide a risk-managed middle ground between stocks and bonds when a level of protection is built into the investment.
The next misconception we often hear is that structured notes are too difficult and complicated to understand. For the most part, this situation can be rectified with deeper understanding and education.
Most standard income and growth notes are composed of a zero-coupon bond, and an options package to generate the payout or return structure. A note like this consists of a zero coupon bond for the principal component and typically some combination of options packaged together for the growth and protection components. Of course, there are certain notes that may exhibit more complicated payouts, but those are less common compared to the notes that are most frequently issued and used by investors.
An income note is slightly more complicated as it consists of a strip of regular coupon payments with a series of short-term call options. The tradeoff for an investor is whether they would be willing to overlay an options strategy with multiple expirations and strike dates on multiple underlyings in their portfolio. Before investing with structured notes, the first task is to understand portfolio objectives. From there, a structured note can be used for either capital protection, yield enhancement or upside participation.
Learning how a bond works and adding an options overlay are the building blocks of starting to understand how a vast majority of structured notes function. Finally, one of the most common misconceptions out there is that banks are betting against those who purchase structured notes. While banks do initially take the other side of a structured note trade they will in many cases immediately hedge their risk.
As such, banks will hedge their risk, often in exchange traded markets like vanilla options for their book of structured notes. They may have an overarching position from all their note issuances which they trade as one unified portfolio.
Individually though, each note they issue is hedged. Some of these municipalities are going to struggle to repay monies that were loaned in the form of municipal bonds. Once again, the global pandemic has decimated that sector as well. If none of these investment tools are going to create a risk-adjusted dividend stream that exceeds the current rate of inflation, what are we going to use for our Yield Bucket?
Structured notes are a great example of one alternative opportunity. We then shop our note to the largest banking institutions on the planet J. Due to the call feature, we recommend multiple notes as opposed to one large note. If one note is called you still have others paying their monthly dividends while we look for a new replacement note.
In a world of low interest rates and increased risks, building a Yield Bucket and adding some structured notes is one way to diversify your portfolio AND increase your dividends. Mike is an Investment Adviser Representative and insurance professional. He has always worked as an independent financial adviser, serving his clients with a comprehensive approach to retirement planning for more than a decade. The appearances in Kiplinger were obtained through a PR program.
The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger. Kiplinger was not compensated in any way. Skip to header Skip to main content Skip to footer. In the case of the FANG notes, Barclays has sole discretion--in other words, without the consent of noteholders--to decide whether to call the notes on specific call valuation dates starting in July Investors therefore have no way of knowing the notes' actual life span.
That will also be the case for a structured note, but only if the stock or other underlying benchmark doesn't close below its barrier value at the time the note matures.
Granted, the FANG note could be viewed as an extreme example of what can go wrong with structured notes. But other structured notes linked to highly volatile underlying stocks or asset classes have suffered from similar woes. Investors in Asia--where structured notes are widely used by individual investors--have reportedly suffered billions of dollars in losses from structured notes tied to oil- and gas-linked indexes.
In almost every case, the final payoff investors receive is based on performance of the underlying asset with the lowest returns. Hidden Costs Not only are the inner workings of these notes complex, but they come with high fees that are invisible to investors unless they read the prospectus.
While investors don't pay these fees directly, they're built into the principal value as a markup or embedded fee. In , the SEC began requiring issuers to disclose estimated fair values for structured notes. We reviewed a sample group of about 50 notes issued in the United States at the beginning of On average, the issuer-reported fair values were about That translates into an average markup or embedded fee of 2.
The Barclays contingent coupon notes have a particularly steep fee structure. That means the notes were sold at a markup of 4. Because the notes have a maturity of about two years, that's effectively an expense ratio of 2. If the notes were called early, investors would end up paying even more in percentage terms.
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