Structured notes could be a good choice for investors looking for increased yield and principal protection. But many structured notes can cause the investor to lose part or all of their principal since there is a lack of awareness of the inherent risks when buying a structured product.
What are Structured Notes?
Structured notes are financial products that appear to be fixed income instruments, but contain embedded options and do not necessarily reflect the risk of the issuing credit. Due to the fact that each one is unique, the risks inherent in any one structured note may not be obvious.
Examples and Uses of Structured Notes
Bonds and Structured Notes
Bell Canada 10.00% 00-14 bonds represented a plain vanilla structured note. The issuer sold the lender a “deep out of the money” option to extend the maturity of the bond to 2014 from 2000. The investor assumed Bell credit risk throughout the term of the bond.
Plain vanilla structures and structured notes include callable, puttable, retractable and extendible bonds. These types of structures are fairly common and most investors do not consider them to be structured notes in the sense of derivative exposure.
Risk and Portfolio Management
Structured notes may be used prudently to mitigate the risks to a portfolio of a systemic shock, for example an adverse economic event that drove down the value of the Canadian dollar. A structured note could be purchased with an embedded Canadian dollar put versus the US dollar. It would be prudent to hedge the currency risk of this event with a structured note along these lines. The premium would be considered insurance, as opposed to speculation.
They may also be used by investors to expose their portfolios to asset classes or markets in which they cannot directly invest due to investment mandates and regulatory restrictions. Due to the fact that the note resembles a bond, with a credit exposure that makes it appear a solid credit, many investors utilize them to get involved with asset classes and markets outside of their general scope of business.
For example, let’s say that Uncle Pipeline issues a structured product, the FinPipe 6.50% Six-Month Note. The investor takes the credit risk of a major financial institution (the stalwart Financial Pipeline!), giving the note a AA(H) credit rating. The investor actually owns a leveraged exposure to the equity of a TSX basket of stocks.
The concept underlying the note is that in a time of market uncertainty the investor may realize a cash benefit from the high premiums for options on individual stocks or a basket of stocks. The payoff is either 6.50%, or common stock if the stock is at or below a certain level. If, however, the market rallies, the coupon payoff decreases significantly.
Structured Notes and Investors
Many structured notes can cause the investor to lose part or all of their principal. Many investors are not aware of the inherent risks when buying a structured product. Structured notes have grown in popularity as investors find it increasingly difficult to utilize derivatives overtly in their portfolios. As with any product with derivative exposure, the investor must understand the costs, cash flows, and risks inherent in the product before making any purchase decision.
- Article by Chand Sooran, Point Frederick Capital Management, LLC