Hedging Risks with Structured Notes

Structured notes are an increasingly popular investment vehicle that can expose investors to different asset classes with unique and customizable risk and return profiles. But how are structured notes formed, and what role can they play in your portfolio?

What is a Structured Note?

Structured notes are complex financial products and how they work varies depending on the specific note. Generally, a structured note combines a zero-coupon bond issued by a bank and an option contract (or multiple option contracts). Together the bond and option contract(s) provide the investor exposure to the performance of an underlying asset or index for a specified time.

The note tracks the index's performance and, at maturity, may offer amplification of the index's returns or downside protection against loss.

For example, imagine a structured note tied to the S&P 500 Index with a five-year duration, a 30% downside buffer in case of loss, and 130% of the underlying index's return participation. If the index has declined at the note's maturity, the investor's principal would be fully protected against any decline of up to 30% in the index. On the other hand, in a positive market, the note's return will be 1.3x the price return of the index. (Note: any terms here are just examples and are subject to change based on market conditions and sentiment.)

This type of product can be a very helpful arrow in a long-term investor's quiver because, in the event of a market drawdown, losses are minimized, but the noteholder still has the opportunity to outperform during positive markets potentially.

Why Do Banks Issue Notes?

With such a beneficial return profile for investors, what is in it for the bank? It is important to understand that when a bank issues a structured note, it is not "taking the other side of the trade" or "betting on what the market will do." Instead, the bank acts as a counterparty and facilitates creating and issuing whatever type of customized product is desired. The bank earns a fee for these services.

When a note is created, the bank earns revenue from the spread on the note. This refers to the difference between the costs of constructing the note and the price at which it is sold to investors. The more efficient a bank is at creating a note, the more profitable it will be for the bank.

Typically, the bank will immediately hedge any new exposure to the market through various risk management techniques. Remember, the bank's role as issuer and counterparty is different from taking a position on the potential outcome of future market movements.

Benefits and Considerations

The main benefits of structured notes are:

• Potential for outperformance versus passive benchmarks: Because of the potential for amplifying an index's return, a note provides passive exposure to an index with the potential for higher returns than just investing directly in a comparable index fund.
  
  
• Hedging against risk: The downside protection in a note allows investors to reduce their portfolio's exposure to the risk of a market decline, thus lowering volatility.
  
  

While all of this may sound too good to be true, there are several important considerations to remember.

• Credit Risk: When you purchase a structured note, you become a creditor to the issuing bank. This means that you depend on the bank's creditworthiness, and if it defaults or faces financial difficulties, you may face a loss of principal.
  
  
• Missing Dividends: Since you do not own the equity index, you are not entitled to any dividends it may pay. This means that when comparing performance, for the note to outperform the total return of the underlying index, any amplification must be more than the make-up for the missed dividends.
  
  
• Complexity: Structured notes are complex and customizable financial instruments. Therefore, each note contains its own unique set of terms. This can make them challenging for individuals to understand. It is important that investors carefully analyze these terms and how the payout structure works before investing.
  
  
• Fees: The costs can vary widely depending on the specific terms of the note, such as the complexity of the payout structure, the underlying asset or index, and its duration. Generally, the annual expense will decrease the longer the note's duration (i.e., time to maturity).

Summary

Structured notes can be used to replace existing exposures in your portfolio with a product that offers downside protection and amplified upside returns. While different complexities and risks are associated with each note, they can play an important diversifying role in a portfolio. However, because of their customization, each note is unique, and it is important to work closely with your investment advisor to ensure that a specific note is appropriate for your individual goals.

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