Understanding structured notes: A comprehensive guide


## **What are structured notes?**

Structured notes are an innovative financial instrument that combines elements of both debt and derivatives, offering investors the opportunity for customized investment outcomes. While these hybrid securities can provide potential returns and principal protection, they also come with certain risks.

![Illustration: Notes + Derivative Instrument = Structured Note](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/structured-note-min.webp)

These derivatives are linked to an underlying asset or benchmark, offering the potential for additional positive returns. Issued by banks and financial institutions, structured notes are marketed to retail investors as a way to earn higher returns than traditional fixed-income investments while providing some degree of principal protection.

## **How do structured notes work?**

Structured notes consist of two main components: the bond portion and the derivative portion. The bond component, which forms the majority of the investment, ensures principal protection, while the derivative portion provides exposure to the performance of an underlying asset, group of assets, or index. The returns on a structured note are tied to the performance of the underlying asset, determined by the terms of the derivatives used.\
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Consider a prominent bank that issues structured products in the form of notes, each having a notional face value of $1,000. These notes are composed of two main elements: a zero-coupon bond and a call option tied to an underlying equity instrument, such as common stock or an ETF reflecting a popular index like the S&P 500. The maturity period for these notes is three years.

**The chart provided below illustrates the progression of these notes from the issuance date to the maturity date.**

![Chart showing the progression of structured notes from issuance to maturity over three years](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/notional-face-value-1000-min.webp)

While the pricing mechanisms governing these values are intricate, the fundamental principle is relatively straightforward. Upon issuance, you pay the face value amount of $1,000. Importantly, these notes offer full principal protection, ensuring that you will receive the original $1,000 back at the time of maturity, regardless of any fluctuations in the underlying asset. This safeguard is accomplished by the zero-coupon bond gradually increasing in value from its initial discounted issuance amount to reach the face value.

Regarding the performance component, the underlying asset is priced as a European call option. If, upon maturity, the asset's value exceeds its value at the time of issuance, it will possess intrinsic value. In such cases, you will earn a return equal to the increase in value on a one-to-one basis. However, if the option is not in the money at maturity, it will expire without any additional returns beyond the principal amount of $1,000.\
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**The chart provided below illustrates a hypothetical example of one of the more complex pay-out structures, sometimes referred to as a “shark fin” pay-out.**

![Chart depicting a hypothetical "shark fin" pay-out structure](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/shark-fin-payout-structure-min.webp)

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**Shark fin pay-out assumptions:**

- Principal protection of 10 percent of initial investment
- 100 percent participation in index gains up to 40 percent, so the maximum return is 140 percent of principal
- Automatic 110 percent return at maturity if the index gains more than 40 percent at any time during the life of the note

In other words, the performance of the underlying asset impacts what the investor gets as follows:

![Table of Shark fin pay-out assumptions, showcasing how the investor's returns are impacted by the performance of the underlying asset](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/Screenshot%202023-06-28%20at%209.29.55%20PM.png)

### Market environment affects note pricing

Structured note returns and pricing are subject to the influence of various market variables. The following outlines a selection of these variables and their impact on the returns of structured notes:

![Table showing the impact of market variables on structured note returns and pricing](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/market-variable-min.webp)

Given that structured notes encompass both a zero-coupon bond and an options package, investors have the opportunity to participate in upward market movements if desired, while also safeguarding against potential declines in prices.

It is worth noting that a significant proportion of structured notes belong to the income and growth categories. Therefore, let us begin by focusing on these two types initially.

When structured notes are linked to stocks, ETFs, or a portfolio of stocks, they should be regarded as a complementary component to the equity segment of an investment portfolio. Furthermore, if the underlying stock or index of the note is associated with small-cap or large-cap investments, they should be included in the corresponding allocation accordingly.

## **Structured notes in portfolios**

Many investors find structured notes to be a valuable tool for managing their portfolios. These notes offer flexibility and customization options that can be adjusted to meet the specific needs of clients. They are often used as a central component of an investment strategy, allowing investors to protect against potential losses while still seeking favorable returns. Structured notes can be tailored to focus on any asset class where downside protection is desired. This means that investors can choose the areas in which they want to minimize risk while still taking advantage of potential opportunities for growth.

In addition to serving as a core holding, structured notes can also be used tactically. They enable investors to take advantage of specific investment themes, sectors, or market trends that may be challenging to implement through other means. This flexibility allows investors to align their portfolios with their desired investment strategies and potentially enhance their returns.

Overall, structured notes provide investors with greater control over their portfolios and the ability to navigate various market conditions effectively. By carefully selecting the features and components of structured notes, investors can customize their investments to align with their risk tolerance and investment goals.

![Pie graph displaying the reallocation of US equities exposure to equity-linked structure notes](https://hedonova.b-cdn.net/Hedonova%20images/%20All%20Hedonova%20blogs/Understanding%20structured%20notes%20A%20comprehensive%20guide/re-allocating-u.s.-equities-exposure-to-equity-linked-structured-notes-min.webp)

## **Understanding terms of structured notes**

When investing in structured notes, it is essential to familiarize yourself with key terms and concepts:

**Issuance:** Financial institutions issue structured notes, which are typically sold through intermediaries such as brokerages or financial advisors.

**Underlying asset:** Structured notes are linked to an underlying asset, which can be stocks, bonds, commodities, currencies, or other asset classes. The performance of the underlying asset affects the value of the structured note.

**Derivatives:** Derivatives are financial instruments whose value derives from an underlying asset. In structured notes, derivatives are used to create customized investment outcomes. For example, options or futures contracts may be employed to structure a note that pays out a fixed amount based on the performance of the underlying asset.

**Investment outcomes:** Structured notes offer specific investment outcomes based on the performance of the underlying asset and the terms of the derivatives used. These outcomes can include fixed returns, principal protection, or participation in the performance of the underlying asset.

## Types of structured notes

Structured notes come in various forms, each catering to different investment objectives. Some common types include:

**Principal protected notes (PPNs):** These notes provide principal protection, ensuring the investor's full principal is returned at the end of the note's term, regardless of the underlying asset's performance.

**Reverse convertible notes (RCNs):** RCNs offer a fixed coupon payment, while the note's value is linked to its reference asset.

**Enhanced participation or leveraged notes (EPNs):** EPNs provide the potential for higher returns through leverage, typically linked to 2x or 3x the return on the underlying asset.

**Hybrid notes:** These notes combine elements of both debt and equity, offering a fixed coupon payment and the potential for capital appreciation through equity ownership in the issuer.

**Credit-linked notes:** These notes are linked to the credit risk of a specific issuer or group of issuers, allowing investors to gain exposure to credit risk without owning the underlying bonds.

**Equity-linked notes:** These securities track the performance of specific equities or equity indices, enabling investors to gain exposure to the stock market without directly owning stocks.

## Advantages of structured notes

**Customization:** Structured notes offer a high degree of customization, allowing investors to tailor their investment outcomes based on their specific goals and risk tolerance. They can choose from a wide range of potential payoffs that are difficult to find in traditional investment products.

**Potential for higher returns:** Structured notes provide the opportunity for enhanced returns compared to traditional fixed-income investments. By incorporating derivatives, investors can gain exposure to the performance of underlying assets, indices, or other benchmarks, which can lead to higher potential returns.

**Principal protection:** Some structured notes, such as principal-protected notes (PPNs), offer principal protection, ensuring that investors receive at least their initial investment amount back at maturity. This feature provides a level of downside protection and can be appealing to conservative investors.

**Risk management:** Structured notes allow investors to manage risk by designing investment strategies that limit losses or protect against market volatility. For example, structured notes can be structured to provide downside protection while capping potential gains, making them suitable for risk-averse investors.

**Diversification:** Structured notes can be linked to various underlying assets or indices, providing investors with the opportunity to diversify their portfolios. This diversification can help reduce overall investment risk and potentially enhance returns.

**Innovative investment opportunities:** Structured notes offer unique investment opportunities that may not be available through other investment vehicles. They allow investors to take unconventional bets on specific outcomes or market conditions, providing access to niche investment strategies.

## Disadvantages of structured notes

**Complexity:** Structured notes are complex financial instruments that require a good understanding of derivatives and their implications. The combination of a debt instrument and a derivative makes them more intricate than traditional investments, necessitating thorough analysis and comprehension of the expected payoffs.

**Market risk:** Like any investment, structured notes are exposed to market risk. Changes in underlying asset prices, interest rates, commodity prices, or foreign exchange rates can impact the value of the structured note. If the underlying derivative becomes volatile, investors may experience losses or not achieve their expected returns.

**Low liquidity:** Structured notes often have limited liquidity, making it challenging to buy or sell them on a secondary market. Due to their customized nature and specific terms, there may not be a well-developed market for a particular structured note. Investors should be prepared to hold the note until maturity, limiting their ability to liquidate the investment if needed.

**Default risk:** Structured notes carry a higher default risk compared to their underlying debt obligations and derivatives. If the issuer of the structured note defaults, investors may lose part or all of their investment. Buying debt and derivatives directly can help mitigate this risk.

**Limited transparency:** Structured notes may lack transparency, making it difficult for investors to fully understand the underlying components, risks, and costs associated with the investment. This lack of transparency can make it challenging to assess the true value and evaluate the investment's suitability.

**Suitability for individual investors:** Due to their complexity and associated risks, structured notes are often considered more suitable for sophisticated and institutional investors. Individual investors with limited knowledge or experience in derivatives and complex financial products may find it challenging to assess and manage the risks effectively.


Structured notes are hybrid financial instruments combining debt and derivatives. They offer customized investment outcomes linked to an underlying asset or benchmark. Investors gain potential positive returns with some principal protection. Structured notes come in various forms, such as principal protected notes and reverse convertible notes. They provide customization, potential for higher returns, and risk management. However, they are complex, have market and default risks, and limited transparency. Suitable for sophisticated investors seeking unique investment opportunities.

Understanding structured notes: A comprehensive guide

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