Why structured notes may not be right for you

For ordinary investors, structured notes seem very reasonable. Investment banks promote structured notes as an ideal tool to help you benefit from outstanding stock market performance while protecting you from poor market performance.

Who doesn’t want the upside potential for downside protection? However, investment banks (sales and marketing machines that, to some extent, focus on promoting their investment products) may not disclose that the cost of such protection usually exceeds the benefits. But this is not the only investment risk you take with structured notes. Let us take a closer look at these investments.

Key points

  • Investment banks issue structured notes, which are debt obligations with embedded derivatives.
  • The value of derivatives is derived from the underlying asset or asset group, also known as the benchmark.
  • Investment banks claim that structured notes provide asset diversification, the ability to benefit from stock market performance, and downside protection.
  • One of the main disadvantages of structured notes is that if the issuing investment bank loses its obligations, investors have to bear significant credit risk, as in the case of the collapse of Lehman Brothers in 2008.
  • Bullish risk, lack of liquidity and inaccurate pricing are other shortcomings of structured notes.

What is a structured note?

A structured note is a debt obligation-basically like an IOU from an investment bank that issued it-with an embedded derivative component. In other words, it invests in assets through derivatives. A five-year bond with an option contract is an example of a structured note.

Structured notes can track a basket of stocks, a stock, stock indexes, commodities, currencies, interest rates, etc. For example, you can have structured notes whose performance is derived from the S&P 500 Index, the S&P Emerging Market Core Index, or both. As long as the following concepts are met, the portfolio is almost unlimited: benefit from the asset’s upside potential while limiting its downside risks. If investment banks can sell it, they can make almost any cocktail you can think of.

What are the advantages of structured notes?

In addition to providing overall asset diversification, investment banks advertise structured notes also allow you to diversify specific investment products and types of securities. However, there may be excessive diversification, which has a negative impact on overall returns. It is important to understand how specific structured notes can be diversified. For example, is there a high degree of correlation between the assets held in the notes?

Investment banks also often promote structured notes that allow you to access asset classes that are only available to institutions or difficult for ordinary investors to access. But in today’s investment environment, it is easy to invest in almost anything through mutual funds, exchange-traded funds (ETF), exchange-traded notes (ETN), etc. In addition, do you think that investing in a complex portfolio of derivatives (structured notes) is easy to obtain?

The only meaningful benefit is that structured notes can have customized expenditures and risk exposures. Some notes promote investment returns with little or no principal risk. Other notes provide high returns in a range of markets with or without principal protection. Despite this, other notes still tout alternatives that generate higher returns in a low-return environment. No matter what you like, derivatives allow structured notes to be consistent with any particular market or economic forecast.

In addition, inherent leverage allows derivatives to return higher or lower than their underlying assets. Of course, we must weigh the trade-offs, because adding a benefit in one place will inevitably reduce the benefit in other places. As we all know, there is no free lunch in the world.

What are the disadvantages of structured notes?

credit risk

If you invest in structured notes, then you intend to hold them to maturity. This sounds good in theory, but have you studied the credibility of the issuer of the note? As with any IOU, loan or other type of debt, you bear the risk that the issuing investment bank may get into trouble and lose its obligations.

If this happens, the underlying derivatives may receive a positive return, and the notes may still be worthless—this is exactly what investors faced during the collapse of Lehman Brothers structured notes in 2008. Structured notes add a layer of credit risk on top of market risk. Never think that just because the bank is a big name, there is no risk.

Lack of liquidity

Structured notes are rarely traded on the secondary market after issuance, which means that their liquidity is very low, which is unbearable. If you do need to exit for any personal reason-or because of a market crash-your only option for early exit is to sell to the original issuer, and the original issuer will know you are in trouble.

If you need to sell structured notes before maturity, the original issuer is unlikely to give you a good price-assuming they are willing or interested in making an offer to you.

Inaccurate pricing

Since structured notes are no longer traded after issuance, the possibility of accurate daily pricing is very low. The price is usually calculated by a matrix, which is very different from the net asset value. Matrix pricing is essentially a best guess method. Who do you think can make guesses? Yes-the original issuer.

Other risks you need to know

Bullish risk is another factor that many investors overlook. For certain structured notes, the issuer can redeem the notes before maturity, regardless of the price. This means that investors may be forced to accept prices far below face value.

The risks don’t stop there. You must also consider tax factors. Investors may be responsible for paying federal taxes on structured bills, even if the bills are not yet due and the investor has not received any cash. Most importantly, when sold, the proceeds may be taxed at the ordinary income tax rate, rather than at the more favorable capital gains tax rate. Each issuance is different, and the US Securities and Exchange Commission recommends that investors read the prospectus of structured products carefully to understand the tax implications.

In terms of price, you may pay too high a price for structured notes, which is related to the issuer’s selling, structuring, and hedging costs.

Open the curtains

What if you don’t care about credit risk, pricing or liquidity? Are structured notes worthwhile? In view of the extreme complexity and diversity of structured notes, we restrict our focus to the most common type, namely the buffered revenue enhanced note (BREN). Buffering means that it provides some but not complete downstream protection. Enhanced returns means that it takes advantage of the upward market returns. BREN is considered an ideal choice for investors who predict weak market performance but are worried about market decline. This sounds too good to be true, of course, it is true.

Example structured notes

A good example is the BREN associated with the MSCI Emerging Market Price Index. This particular security is an 18-month note that provides 200% upside leverage, 10% downside buffer, and 24% performance cap. For example, on the bright side, if the price index for the 18-month period is 10%, the return on the bill is 20%. The 24% cap means that no matter how high the index rises, you can earn up to 24% on the notes.

On the downside, if the price index drops by -10%, the bill will be flat and 100% of the principal will be returned. If the price index falls by 50%, the bill will fall by 40%. I admit that this sounds very good-unless you take into account the exclusion of caps and dividends. The chart below illustrates the performance of the security relative to the benchmark from December 1988 to 2009.

MSCI Emerging Market Price Index and BREN Performance, 1988-2009.

Understanding index and BREN performance

First, pay attention to the area marked “Capped!”. The graph shows that the upper limit of 24% limits the number of times the note performs relative to the benchmark. For example, the 18-month return of the index as of February 2000 was 107.1%, while the upper limit of the bill was 24%. Second, pay attention to the area marked “Protection?” See how much the buffer zone can protect the downstream from losses?

For example, the 18-month return for the index as of September 2001 was -49.7%, while the bill was -39.7% because of a 10% buffer. Yes, the note performed better, but the -39.7% drop seems difficult to protect the downside. More importantly, these two periods show that the note gave up 83.1% (107.1%-24%) to save 10% downside, which seems to be a very bad deal.

special attention items

Please keep in mind that this note is based on the MSCI Emerging Market Price Index and does not include dividends. If you invest directly in the MSCI Emerging Market Index through a mutual fund or ETF, you will reinvest these dividends within 18 months. This is a huge transaction that retail investors mostly ignore, and investment banks hardly mention it.

For example, the average 18-month return of the emerging price index from 1988 to September 2009 was 18%. The Emerging Total Return Index (price index, including dividends) has an average 18-month return of 22.4%. Therefore, the correct comparison of structured bill performance is not for the price index, but for the total return index.

Finally, considering how much upside space is given up, we need to understand how much downside protection the 10% buffer provides. Looking back at the period between October 1988 and September 2009, the buffer will only save you 6.6% on average, not 10%. why? Dividends will reduce the value of the buffer.

For example, for the 18-month period ending in July 2001, the MSCI Emerging Total Return Index was -36.4%, and the MSCI Emerging Price Index was -38.6%, so structured notes were -28.6%. Therefore, in these 18 months, the 10% buffer value is only 7.8% (36.4%-28.6%) compared to direct investment in the index.

Bottom line

Structured notes are complex and may not be suitable for ordinary individual investors’ investment strategies. The risk/reward ratio is usually too poor. The illustrations and examples provided by investment banks tend to highlight the advantages, while downplaying their limitations and disadvantages. The fact is, from a historical perspective, the downside protection of these notes is limited, while the upside potential is also limited. In addition, please consider the fact that no dividends can help ease the pain of decline.

If you choose a structured note anyway, be sure to investigate the fees and costs, estimated value, expiration date, redemption function, income structure, tax impact, and the issuer’s reputation.

InvestingClue does not provide tax, investment or financial services and advice. The information provided does not take into account the investment objectives, risk tolerance or financial situation of any particular investor, and may not be suitable for all investors. Investment involves risks, including possible loss of principal. Investors should consider hiring qualified financial professionals to determine appropriate investment strategies.

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