Structured notes are a powerful investment product that should be considered as part of your portfolio. The right structured note combines protection for your money with the upside for investment gains.
There are lots of complexities that can be built into a structured note product, so this is one of those investments where we recommend you speak with a financial advisor to ensure that you don’t get burned.
Let’s dig into what structured notes are, what to watch out for, and how to invest in them.
What Are Structured Notes?
At its core, a structured note is debt investment. You’re essentially lending money to a company, and in return you have the potential to make a return on it.
The most attractive thing about a structured note is that it has the unique ability to fully protect your investment principal while giving you some potential for gains. Not all structured notes protect your investment principal so you’ll want to find ones that are listed as “Principal Protected Notes”.
To help us better understand how structured notes work, let’s consider an example. A structured note from Bank of America that is linked to the S&P 500 index might be set up in the following manner:
- You buy the principal protected structured note for $100 and agree to hold it for three years
- You will get an additional payment based on 60% of the gains of the S&P 500 index over the three year period
- After three years, you get your $100 back plus 60% of whatever gains the S&P 500 index has accumulated
- If the S&P 500 goes down, then you still get your $100 back
Let’s illustrate this using some sample numbers.
Principal investment into structured note = $100
Term = 3 Years
Initial S&P 500 index level = 1,000
Final S&P 500 index level (after three years) = 1500
Variable Return = Your get 60% of the gains of the S&P 500
Amount of money you get after 3 years = Principal investment + [Principal investment] X ( [final index level] – [initial index level] ) / [initial index level] ) X 60%
Amount of money you get after 3 years= $100 + $100 X (1500-1000) / 1000 X 0.60 = $130
As you can see, you would’ve made more money if you just invested the $100 directly into the S&P 500 index. However, if you did this and the index went down then you would’ve lost money. With the principal protected structured note, you’re giving up some of your potential gains in exchange for security.
Remember the number one rule in investing is “don’t lose money”. This is why principal protected notes should be considered for part of your portfolio as long as you do your homework, and make sure the terms and conditions of the note are reasonable.
Structured Notes – What to Watch Out For
Structured notes are complex enough that the average investor won’t want to spend hours trying to understand it. Each note also has a significant amount of documentation and unique characteristics that need to be reviewed prior to purchase.
If you’re looking to buy structured notes, then engage a trustworthy financial advisor who has a fiduciary duty to your best interests.
Here are some of the points that you should bring up in your discussions with a financial advisor prior to purchasing any structured note.
Does the structured note have full principal protection? Not all structured notes do! Make sure you’re buying principal protected notes, and that the company who’s issuing the structured note has a good credit rating. Your principal will be safe as long as the issuing company doesn’t go bankrupt.
What are the fees? Many structured note issuers build hidden fees into the product. They might not officially be called “fees”, but they’ll decrease your potential returns. Your financial advisor needs to be able to tell you exactly what the structured note will charge you for owning it.
Can a “call” be made on the structured note by the issuing company? Some notes are set up such that the company that issues it can force you to sell it back before the maturity date. This can have significant disadvantages for you depending on how this call option is set up.
What is the structured note linked to? We usually want the performance of the structured note to be linked to some asset class. This can be a specific industry, commodity, or entire stock markets. Make sure you know what the structured note is linked to, and whether that asset class makes sense for your portfolio. For example, if 90% of your investments are already in S&P 500 index funds, then it doesn’t make sense to buy structured notes that are also linked to the S&P 500 index. You need to diversify!
How are gains calculated? If you have a three year structured note, then it would make logical sense that any gains would be calculated based on the price of the linked asset at the beginning of the three years versus the end of the three years. However, many structured notes calculate the gains based on the yearly closing price that is averaged out over the term. You need to understand how your structured note works.
For structured notes linked to stocks or indexes, are dividends included? A lot of structured notes don’t include the dividend portion of the asset they’re linked to. This isn’t necessarily a deal-breaker, but it does need to be factored into the calculation to determine if the particular note makes sense for you.
Are your returns capped? Some structured notes will put a cap on your gains. For instance, if you have a structured note linked to a stock index and that stock index goes up 500%, the structured note might limit your gains to only 25%.
A good way to determine if a structured note will actually work for you is to ask your financial advisor to run a calculation using historical data. If you’re considering buying a three year structured note today, then ask them them following:
If I had invested $100 in this note three years ago and sold it today, how much money would be in my account?
This will take away the ambiguity of any hidden charges, and give you a crystal clear view of your returns.
How to Invest in Structured Notes?
Most of the good structured notes cannot be bought directly bought by consumers. You’ll need to engage a financial advisor who has access to structured notes.
Also, make sure you shop around to find the best deal! There are endless varieties of structures notes, and you should talk to at least three different financial advisors to get a good feel for what is out there.