By Founder & CEO Scott Savage.
We want to warn you about an investment product called structured notes. These derivative instruments typically purport to provide investors with a coupon payment higher than available in the bond market, as well as downside protection from the underlying reference asset, which is often a stock-based investment like the S&P 500 Index.[1] Sounds great, right? What could go wrong? A lot!
Below, we summarize structured notes as well as detail concerns we believe investors should understand before investing one penny. While risk management is the responsibility of each advisor who touts these investments, we want you to be aware of the risks in case someone recommends structured notes to you.
Summary
A structured note is a derivative instrument designed to typically provide both a regular coupon payment as well as some degree of principal protection compared to an underlying (usually stock) reference asset. Typically, the investor purchases an initial issue of the note from the sponsor (usually an investment bank) in exchange for coupon payments over the length of the note (often 1 to 5 years).
Generally, if the underlying reference asset only declines a little over the length of the note, the investor has a pre-specified level of principal protection and still receives the coupon payments. If the reference asset value falls below the predetermined knock-in level (the minimum value specified in the contract to receive coupon and principal payments), you may not receive all of the coupon payments and your principal amount would decline. When the reference asset increases over the note length, the investor usually receives the coupon payments and some principal upside based on the participation rate.[1]
Source: “Spotlight on… top issuers in the US“. Structured Retail Products, 07-Jan-2022, structuredretailproducts.com.[2]
Advantages
An investor can receive a coupon rate that is higher than yields available in the bond markets, while receiving some downside principal protection if the underlying reference asset declines.
Some structured note platforms are creating more competition among sponsors, which can help to create more investor-friendly structured notes.
Many banks offer structured notes for a wide variety of underlying stocks, indices, and other financial assets.
Concerns
Most structured notes are relatively complicated, often with dozens of pages of details such as protection (specified knock-in levels), maturity, coupon rates, and underlying reference assets.
Most structured notes are subject to multiple layers of fees, and the fees are often difficult to understand.
In terms of issuers, structured notes are primarily issued by large, predominantly Wall Street banks.[2]
Structured notes tend to have maturities of 1 to 5 years, meaning upon maturity you will have to review newer structured notes if you want to continue investing in structured notes.
Many structured notes can be redeemed (called) by the issuer, either automatically triggered based on the underlying reference investment or whenever the issuer has the right to call.
Typically, there are no federal or state insurance guarantees on the principal invested in structured notes. Additionally, structured notes tend to be senior, unsecured notes by the sponsor. If the sponsor is unable to make interest and / or principal payments, the investor may not receive the full note value.
Many structured notes do not provide full downside protection in case the reference asset falls below the knock-in level. The downside market protection may not fully cover your investment in more volatile market periods.[4]
Most notes have a relatively illiquid secondary market. Some notes allow the investor to sell back the notes to the sponsor, often at a discount to the current value.
Interest (excluding principal) from the notes can be complicated, and often considered taxable income if held within a taxable account.
Sponsors typically measure reference assets without dividends and other distributions.
Structured notes are over-the-counter investment products, which have less regulatory supervision compared to mutual funds and ETFs.
The total market for structured notes is not as competitive (particularly on costs and product features) as other investment products such as mutual funds and ETFs.[1]
Structured notes are not standardized across issuers.
In recent years, the U.S. Securities & Exchange Commission (SEC) has issued Investor Alerts & Bulletins detailing the risks of structured notes. In particular, the SEC encourages you to answer the following questions before purchasing a structured note:[5][6]
Conclusion
As we contemplate our duty to our clients as fiduciaries, SJS does not recommend structured notes to clients. They tend to be complex, primarily offered by Wall Street banks, have multiple layers of fees, and require a lot of work to fully understand each structured note.[1][2][4][5] Finally, we are not aware of any well-regarded institution or endowment fund that invests in structured notes. We wonder why?
Important Disclosure Information & Sources:
[1] “Why Structured Notes Might Not Be Right for You“. Jason Whitby, 11-Dec-2021, investopedia.com.
[2] “Spotlight on… top issuers in the US“. Structured Retail Products, 07-Jan-2022, structuredretailproducts.com.
[3] “Barclays to Book $591 Million Loss Due to Debt-Sale Snafu“. Anna Hirtenstein, 28-Mar-2022, wsj.com.
[4] “Structured Notes: The Risks of Insuring Against Risks“. Jason Zweig, 17-Oct-2014, wsj.com.
[5] “Structured Notes with Principal Protection: Note the Terms of Your Investment.” United States Securities and Exchange Commission, 01-Jun-2011, sec.gov.
[6] “Investor Bulletin: Structured Notes.” United States Securities and Exchange Commission, 12-Jan-2015, sec.gov.
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