Structured notes: what they are and why they might be an investment option for you

In the face of global uncertainly – which has been in large supply of late – capital preservation is top of mind for many investors. Rising inflation, the consequent hiking of interest rates, recession fears, war worries, pandemic after-effects and crypto crises have made the investment landscape a precarious one, and the protection of investments a priority.

It’s against this background that structured notes can offer an interesting opportunity for investors.

But what are structured notes?

Structured notes are “pre-packaged” investment products that have a fixed term. They can vary in their structure and have different rules and functions, but generally consist of a combination of different financial products. That’s why structured notes are also known as a “hybrid security”.

Often a structured note will be made up of a capital amount that is protected (a bond), as well as a portion that is linked to the return of an underlying asset (the variable element of the investment). The latter isn’t a direct investment, but rather tracks the value of another product – in other words, a derivative.

This derivative can be  linked to a variety of investment assets: a single share or an equity index, commodities or even currencies. The returns of the structured product are linked to these assets which can be structured to provide a variety of different payoff profiles  depending on how the structured note is constructed.

Most Structured notes are designed to protect the investors initial investment via the bond element. The bond element is predictable (thus giving the investor the security that the initial investment amount will be secure), while the underlying return of the  derivative element is unpredictable e.g the return of an index is not known until the product expires. The return on the latter element will depend on the underlying asset’s performance.

Structured Products can be designed to  protect all of your capital amount or some of it. Generally the greater the level of capital protection will result in less participation in the growth of the underlying asset and visa versa.

An example

Let’s look at an example of how a structured note might work. 

Our imaginary investor opts for a structured note that that aims to return the initial investment at maturity plus an interest payment that is linked to the performance of an underlying asset (for example, the Euro Stoxx 50 index) over a 5-year period.

For every R1000 invested:

• R700 is used to purchase a zero coupon bond which will grow to R1000 at maturity providing the capital protection. (The provider of the structured note can secure a rate of interest over 5 years that is enough to return the initial investment.)
• The balance of R300 is used to buy options over the underlying asset which provide the performance element.

The performance element will determine the final return.  If the Euro Stoxx 50 performance is positive at maturity, then the investor will receive the initial investment plus an amount based on the Euro Stoxx 50’s performance. If the Euro Stoxx 50 performance is negative or flat at maturity, then only the initial investment amount will be returned.

“Like an investment in equities or an index, the return on structured products is dependent on the return of the underlying asset, which cannot be determined upfront … it is subject to the return of the equity or index,” says Investec’s Brian McMillan.

Why would I invest in a structured note?

Structured notes are gaining in popularity for investors who want to protect their investments while still having an opportunity to gain from the potential upside of investment growth. In a nutshell, they offer the possibility of protecting portfolios while generating income. This means reduced volatility in a time of global uncertainty.

“Structured products provide investors with the best of both investment worlds – the stability of bonds with the growth potential of equities. By combining these two elements in one product the investor has a pre-defined investment outcome,” adds McMillan.

In addition, structured notes can also offer exposure to assets that are otherwise difficult for individual investors to access. Again, they offer this investment alternative while providing the security that your initial investment is protected. They are also attractive because they vary in maturity terms, investment amounts and risk/return profiles and so investors are able to pick and choose structured notes that suit their individual investment needs.

Returns on structured notes are usually paid on maturity of the product, and because it’s a long-term investment product, investors need to factor in the holding term of the product.

Advantages of Structured Notes

• In most cases, the principle is protected – this means you will get your initial investment amount back, no matter the performance of the underlying asset.

• They can give investors exposure to assets that they can’t usually access.
• They can complement a diversified portfolio.
• For South Africans, it can mean investing in global equity markets but with capital protection.

Disadvantages of Structured Notes

• Structured notes mean trading potential higher growth for capital protection.
• Early termination of the product can be a problem. There are often costs associated with accessing an investment before the end of the term. Also, the value of the investment cannot be guaranteed with early termination, so it is also possible to lose out on this front.
• If you don’t invest with a reputable institution and don’t receive protection for your principal amount, risk enters the equation. “Structured products are issued by banks and as such investors are taking credit risk on the bank that issues the product. Investors need to be aware of the credit worthiness of these banks and any additional credit that is added to the issuing bank,” says McMillan. “Having said this, most structured products are underwritten by the largest banks globally and there have been no major credit impairments of structured products even in the global financial crisis.”