Structured Notes: What you need to know

A structured note is a debt obligation with a built-in derivative component. A five-year bonus with an options contract, for example. A structured note can track a basket of stocks, a single stock, an index of stocks, commodities, currencies, interest rates and more. The concept is to benefit from the bullish potential and at the same time limit the disadvantages.

What is a structured note?

Within the sophistication that exists in financial products , we can find instruments such as structured notes that are a combination of debt and equity with limited risk .

How does a structured note work?

This instrument was designed to optimize returns , reducing risks , combining debt and equities, that is, with the part invested in fixed income, capital is guaranteed and, with variable income, the highest profit is sought ; usually the variable part is invested in financial derivatives that are referenced to variables such as interest rates, currencies, stocks, commodities , etc.

The advantage of structured notes is that they are made-to-measure instruments and risks can be limited. The variable part is what can give us great returns, because they are usually very aggressive investments

In the case of the notes as mentioned above, the losses can be defined, since the investor chooses how much he is willing to lose, usually in the worst case the investor does not earn returns but his capital is guaranteed , when he has a more aggressive profile, decides to take more risks and is willing to take some loss, but if the goal is reached, the gain is greater.

One of the disadvantages is that due to the nature of the instrument, they are long term, it is a product with little liquidity. Most of the time the investor must wait for the expiration;  but without a doubt they are a good option to invest , it is recommended to only have a part in the investment portfolios .

How do structured notes work?

  • First the investor contacts his financial advisor or intermediary to buy a structured note.
  • The second step is that the adviser or intermediary invests the money simultaneously in a fixed income instrument and also in a derivative.
  • In fixed income, the total amount is invested, minus the difference between premiums paid and collected. Upon expiration, the total investment is received.
  • And the derivative will depend on the behavior of an underlying equivalent to the profit that the investment in fixed income gives.
  • Once the expiration date arrives, the investor will receive their initial capital plus a prize (in case the derivatives generate profits).

Structured Notes Operation

Structured Notes are financial instruments issued by an intermediary as an investment alternative where returns higher than those of the fixed income market can be obtained , generally having a guarantee of the capital or a percentage of this invested at the time of maturity.

Through Structured Notes, optimal structures are available that adapt to the expectations and risks that are willing to take. The flexibility of the notes is such that they adapt to their needs, achieving at the same time important returns and the protection of the invested capital.

The notes are referenced through:
  • Exchange rate
  • Interest rates
  • Indices and Actions
  • The paper is Risk
  • Liquidity in pesos only at maturity
  • Minimum amount of investment
  • They are operated through the custody agreement of Patrimonial Banking Securities
  • The settlement for the case of exchange rate, indices and shares is 48 hours and 24 hours for interest rates
  • The exchange rate used as reference is the 'FIX' and TIIE interest rates for a period of 28 days

In general, these are instruments in which, unlike others such as savings deposits, PRLVs or subordinated obligations, returns on initial investment are determined based on changes in certain financial assets, such as interest rates. , the price indexes or the currencies , in such a way that if the variation of the interest rate was, for example, 10%, then the yield on the deposited investment will be 10%. These Structured Notes can be created, for example:
  • with Futures Contracts or Option on the Price and Quotation Index (IPC) of the Mexican Stock Exchange
  • with Options on the NASDAQ 100 ® Index Tracking Stock (QQQSM)
  • about the S & P500® Index (IVV)

All of them are listed in MexDer , among other possibilities that this Derivatives Exchange makes available to the investing public.

A recent category of Structured Notes, denominated in US dollars , is issued by international financial institutions with public debt obligations as backup . In effect, financial intermediaries issue Structured Notes supported by public debt of the Republics of Venezuela , Ecuador and Argentina. In turn, the Republic of Venezuela through its development bank Fondene has acquired these Notes that are subsequently placed in Venezuelan banks. For these, their acquisition through bolivares at official exchange allows them to obtain huge profits by repositioning them in parallel currency markets in which the price of the dollar almost doubles the official exchange rate.

The structured notes are used as an investment alternative, with them you can get to obtain a performance superior to those of the fixed income market. One of its main characteristics is that they adapt to the expectations and risks that the investor is willing to take because they have partial or total protection of the capital invested.

They receive this name because they are considered a hybrid product that is constituted by two or more financial instruments that are: a fixed income asset (which provides the protection and return of capital) and a derivative instrument (usually they are options that allow profitability to be linked from the product to an asset).

The advantages of investing in structured notes are:
  • Transparency: they indicate which are the possible scenarios to which the investor can face. And it stipulates what is the maximum and minimum yield that can be obtained.
  • Liquidity: although the structured notes have a term of validity, there is always a secondary market that allows the investor to sell ahead of time.
  • Accessibility: there are structured notes that can be acquired with low capital.
  • Diversification: allows you to invest in several notes at the same time. There are three types of notes: with guaranteed capital at maturity, with participation on the underlying, with coupons.

There are five factors that influence the price of structured notes:
  • The evolution of the price of the underlying asset
  • The volatility
  • The interest rate
  • The change of the rating of the issuer
Structured notes are one more option if you are investing, with the help of a financial advisor and an investment strategy you can make the most of it.

Risks you need to know

If you invest in a structured note, then you intend to hold it until it expires. That sounds good in theory, but did you investigate the creditworthiness of the issuer? It is possible that the issuer has to give up the debt. Never look at a big name and suppose everything will be fine.

Let's suppose that the issuer is financially healthy. That's good news. Let's also suppose that an investor is financially healthy. It is also good news. But what happens when there is a medical emergency, a job loss or any other unexpected event that requires significant capital?

If you intend to sell a structured note to release capital, you probably have no luck. The structured notes are very illiquid. The only possibility that it will have to sell is for the original issuer (unlike in the secondary market), and that original issuer will know that it is in a bind. Therefore, the original issuer will not give you a good price. After all, structured notes are based on the prices of the parent, not the net asset value.

The risk of calls is another factor that many investors overlook. For some structured notes, the issuer may exchange the note before it expires, regardless of the price. This means that it is possible for an investor to be forced to receive a price that is well below the nominal value.

The risks do not end there. You should also consider the tax factor. Since structured notes are considered payment instruments, investors will be responsible for paying annual taxes on them, even if the promissory note has not reached maturity and they are not receiving any cash. In addition, when it is sold, it will be treated as ordinary income, not as a capital gain (or loss).

Regarding the price, it is very likely that it pays more for a structured note, which is related to the costs of sale, structuring and coverage.

The Bottom Line

Structured notes are complicated and are not always designed to be in the best interest of the average individual investor. The risk / reward ratio is simply poor. If you choose structured notes anyway, be sure to investigate the fees and costs, the estimated value, the due date, if there is a call function, the payment structure, the tax implications and the creditworthiness of the issuer.