Last week, we defined alternative investments and explored one of the most common products within this category: REITs. If you would like a refresher or haven’t had a chance to review it, it’s a short 3-minute read here. This week, we’ll explore another product under the alternative investment umbrella: the structured note.
What is a structured note?
A Structured note is a financially engineered product (or vehicle). Sounds made up, right? Well, from my experience, if there is a creative method of making money, someone is bound to find it!
Structured notes are engineered, but they are engineered with the goal in mind. These products usually consist of at least two components. The first is a bond, and the second is a derivative. Most of you have likely heard of bonds but may not be familiar with the term derivative (in finance lingo).
Derivatives are where a majority of returns come from within the structured note product. A derivative ‘derives’ its value from an underlying asset or index. This can be a market index such as the S&P 500 or individual stocks, currencies, commodities, or other equity products. These derivatives are most commonly purchased as call or put options. We’ll keep the discussion around put and call options for a future post, but let’s explore the composition of structured notes in more detail.
Here's how structured notes work:
First and foremost, there are multiple different kinds of flavors of this ice cream, and we’re not going to explain them all. However, for this example, we’ll keep it reasonably simple, discussing the use of a principal-protected structured note.
As mentioned above, the structured note includes a bond and a derivative. Specifically, in a principal-protected structured note, the bond is a zero coupon bond. Hold on there, Summit, you can’t throw around terms like that! Ok, well, a zero coupon bond has the same components as a traditional bond (coupon, maturity date, and face value), but there are zero annual or semi-annual coupon payments in this fixed-income security. In most bonds, there are coupon payments that support as a form of income for the investor; for this principal-protected structured notes, the zero coupon component is engineered to protect the principal.
Let’s walk through an example calculation
To illustrate how this works, let’s say you’ve got a cool $10,000 ready to invest. You’d like to get good market exposure but don’t want the downside risk and volatility of the market. So, you decide to purchase a zero-coupon bond. Since the bond does not have a coupon, you can get it at a discount. Who doesn’t like a good deal/sale!? For the sake of this example, we’ll assume that interest rates were 5% on a two-year treasury. This means you could purchase the bond at approximately 90% of face value ($9,000 minus fees) and then invest the remaining 10% as a 2-year call option with a strike price at current value where you’d like. To get good market exposure, let’s say you pick an index like the S&P500.
So, if the S&P 500 index declined in value (from the day of purchase) through the end of the term, you would not exercise the call. However, if the S&P 500 went up in value, you would have an option to exercise the call. In both cases, the original principal would still be ‘protected’ at the maturation of the bond, and if the index outperforms, the upside is also realized.
Summary
Structure
They are complex products that combine a bond with a derivative element. The bond component provides a basic level of security, while the derivative allows for the return to be linked to the underlying asset's performance.
Return
The payout you receive depends on how the underlying asset performs. Various types of structured notes are designed for different goals, such as growth or income.
Benefits
Structured notes can allow investors to access specific market segments or gain exposure to assets they might not otherwise invest in directly. In certain situations, they can also potentially provide higher returns than traditional fixed-income investments.
Risks
Keep in mind that structured notes are not without risks. They can be complex and challenging to understand, and they may involve lower liquidity and issuer default risk compared to other investments.
I’m a chocolate chip guy
We’ve only tried/explored one flavor of ice cream at the shop. The principal protected note is maybe the chocolate chip ice cream. Still, we can continue to add a peanut butter drizzle (like our Financial Coach Lindsey prefers), sprinkles (like buffers), waffle cones (put options), or combine multiple structured notes to come up with the competition to Baskin Robin’s 31 flavors. The flavor you pick is all based on your risk tolerance, goals, and time horizon. Structured notes are complex products, and I don’t recommend them to anyone early in their investing journey. Set your foundation and then explore the alternative investments when ready. Our Financial Advisor Team at Whitaker-Myers Wealth Managers is well-versed in alternative investments, and we are here to guide you with the heart of a teacher. Schedule some time with one of our team members to walk you through various investment strategies to align your finances with your life goals.