In the current economic landscape, advisors may be seeking alternative strategies to diversify portfolio risk, enhance returns above public market performance, or generate income beyond traditional fixed income. Learn why some advisors are turning to structured notes.
What are Structured Solutions?
Structured notes have long been used by certain advisors to seek a variety of different objectives, some of which include:
Aiming to mitigate equity volatility
Targeting absolute returns; and/or
Incorporating potential yield-enhancing strategies
Structured notes can be used: 1) as an allocation tool for portfolios; 2) tailored to express a particular view on the markets; and/or 3) to supplement existing portfolios with the potential for yield, growth, or protection.
For those who may not be familiar, structured notes (commonly known as structured investments or structured products) generally include senior unsecured debt obligations of an issuer, which are typically constructed of a zero-coupon bond with an options package along with built-in origination costs to create a single security. Such a structured solution seeks to enable investors to achieve a defined payout that may be linked to an index, a stock, or even the price of gold.
Below is an illustration of a structured solution with downside protection, whose payout could be similar to a combination of a zero-coupon bond with a package of options linked to an underlier. In addition, origination fees are generally built into the initial price of the investment. At maturity, the zero-coupon bond generally accrues to its par value, and the investor would be left with its principal and any market appreciation of the underlying asset. As with all structured notes, there are inherent credit risks and investors may lose some or even all of their investment.
In the United States, more than $94 billion was issued in structured notes in 2021—–which was approximately 14% of the total global issuance. As the structured notes market becomes more accessible, independent wealth managers now have an opportunity to customize structured notes to a given client’s risk appetite and expectations.
Types of Structured Solutions
Structured solutions can generally be broken down into three broader product categories focused on:
Growth;
Yield; or
Protection.
Some advisors on the CAIS platform have considered “yield notes” as a strategic sleeve in their clients’ asset allocation as a part of their alternative investment or high-yield bucket—right next to private credit, real estate or high-yield fixed income. Many structured notes that involve coupon payments tend to have more attractive pricing terms during periods of elevated market volatility, as the core pricing components of these investments conventionally involve selling put options, and heightened volatility generally increases option prices. However, many advisors will caution against trying to “time the market” for volatility spikes versus strategically allocating either quarterly or monthly on a consistent basis to avoid being stuck with cash on the sidelines.
The Fed is currently trying to quell inflation through monetary policies, which has resulted in increased interest rates. As interest rates increase, zero-coupon bonds are generally priced at more of a discount to produce a yield to maturity that is competitive in the market. Zero-coupon bonds are traditionally a large component of a structured solution, and higher discounted zero-coupon bonds provide issuers more room to purchase options when forming the structured solution. This may give issuers more flexibility to offer products with the potential for greater returns and protection.
Some Risks of Structured Solutions
Structured notes aren’t all fun and games. Just like any investment, they come with their fair share of risks.
Structured notes are expected to be held until they reach their maturity date, you must trust that the issuing bank will still be around when that day comes, thus exposing the investor to credit risk. It may sound far-fetched but tell that to Lehman Brothers, which, before filing for bankruptcy in 2008 after 161 years in business, was the fourth-largest investment bank in the United States.
In addition, structured notes are effectively an illiquid investment with little to no way of getting out early without the possibility of potentially taking a substantial loss. If you need to sell before full maturity, you’re basically beholden to whatever the issuer is willing to pay.
Advisors considering an investment in structured notes should carefully consider any related materials describing such a product, and its risks, including but not limited to the following specific risks:
Market risk
Reinvestment risk
Credit risk
Liquidity risk
Tax treatment
Dividends and distributions on underlying assets
Principal risk
Structured notes are increasing in popularity, but that doesn’t necessarily mean they’re for everyone. Take your time, do your research, and figure out what makes the most sense for your clients.
A version of article originally appeared on wealthmanagement.com
