I read an article that described structured notes as “Boomer Candy”. Retirees seem to eat up the idea that they can participate in positive market returns while still protecting principal. What are structured notes and are they something you should incorporate into your portfolio?
Structured notes are debt securities issued by financial institutions that combine traditional fixed-income instruments with derivatives. They are designed to meet specific investment strategies and can be linked to various underlying assets, such as stocks, indices, currencies, or commodities. Unlike traditional bonds, structured notes offer the potential for higher returns, but they also come with unique risks.
Structured notes typically have several key components. Most structured notes offer a degree of principal protection, meaning investors may receive at least part of their initial investment back at maturity, depending on the structure of the note. However, this is not guaranteed for all notes. The performance of a structured note is tied to an underlying asset, which can affect the return on investment. For example, a note linked to a stock index may provide returns based on the performance of that index over a specified period. Structured notes come with a defined maturity date, at which point investors may receive their initial investment plus any additional returns based on the performance of the underlying asset. The payout structure varies widely among notes, with some offering capped returns, while others may provide leveraged exposure to the underlying asset.
Structured notes have the potential for higher returns than traditional fixed income investments, and may offer additional diversification than holding just traditional stocks and bonds. However, they come with significant drawbacks. Structured notes can be complex financial instruments, and understanding their structure, features, and risks is crucial. Investors must carefully review the terms and conditions of each note. Also, because structured notes are issued by financial institutions, investors face credit risk. If the issuer defaults, investors may lose some or all of their investment (Lehman, anyone?). Most importantly, many structured notes are not traded on secondary markets, which can limit liquidity. Investors may have difficulty selling their notes before maturity without incurring steep losses.
Take for example an excerpt from the prospectus of a structure note issued by Goldman Sachs and distributed by Chase Private Client: “The estimated value of your notes at the time the terms of your notes are set on the trade date… is expected to be between $900 and $930 per $1,000 face amount, which is less than the original issue price.” $900 per $1000 face amount?! That is literally a 10% loss on day 1 of the investment. Why such a steep decline? Because Goldman Sachs and JP Morgan Chase have to get paid!
What most investors don’t realize is that these structured notes can often be replicated through simple options structures, at a fraction of the cost. The most popular structure is a note linked the SP500 with protected downside and capped upside. Before buying one of these notes, compare the upside potential on the structured note to the upside potential on an index collar strategy that Komich Capital could build for you. Let’s talk!
