Ep. 186 – Structured Notes – Frequently Asked Questions
Have you heard about structured notes, and what questions do you have about them?
Structured notes are issued by a bank to perform in either the risk management growth or income categories. A bank looks at elements such as interest rates, volatility in the market, and some indices before issuing structured notes.
In this episode of the Secure Your Retirement podcast, we talk about structured notes, what they are, how they work, and their purpose over a glass of cabernet sauvignon wine. Listen in to learn about the coupon and principal barriers and how we work to minimize the risk.
In this episode, find out:
- How structured notes are built to give us risk management growth or income.
- How the bank issues structured notes and the risk attached to the bank you choose.
- How we build structured products to minimize the risk occurring to less than 10%.
- How the coupon barrier works and protects you from losing your principal.
- Why we have to think about the issuing bank and barriers regarding structured notes risks.
- Factors to consider before buying or selling structured notes to avoid losing money.
- What it means for the structured notes to be “called” and how we work around that.
- Why the availability and affordability of structured notes make them good tools during volatility.
- “Structured notes are structured to give us risk manage growth or income.”-Radon Stancil
- “On the principal barrier, the only way you can lose money in this structured note is at the end of the term, not on the month.”– Murs Tariq
If you are in or nearing retirement and you want to gain clarity on what questions you should be asking, learn what the biggest retirement myths are, and identify what you can do to achieve peace of mind for your retirement, get started today by requesting our complimentary video course, Four Steps to Secure Your Retirement!
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Here’s the full transcript:
|Radon Stancil:||Welcome, everyone, to our Secure Your Retirement podcast. And here we sit on the last Monday of November. It’s unbelievable. This is our Wine Down, but it’s going to be power packed. So, Morgan, can you tell us a little bit about what we’re going to talk about today?|
|Morgan Dunn:||We are talking about structured notes today and the frequently asked questions around them. To start it off, we’re going to just cover what they are, how they’re issued, who they’re issued by. How do they work? What are the risks around them? Can you sell them? When would the notes get called? And what are the costs to buy them? But before we get started on that, I wanted to talk a little bit about the wine that we’re drinking.|
|Radon Stancil:||Oh, yeah. Okay.|
|Murs Tariq:||It’s a Wine Down, after all.|
|Radon Stancil:||Well, if you think that’s important.|
|Morgan Dunn:||Let’s get the whole Wine Down part, Radon.|
|Murs Tariq:||Ready to jump right into business.|
|Morgan Dunn:||Today we are drinking a Cabernet Sauvignon from Joel Gott Winery in California. It’s in the Napa Valley. And it’s kind of a fruity forward cabernet, I would say.|
|Radon Stancil:||Yeah, I think it’s pretty good. But, I mean, wine is wine. We don’t want to talk about wine. Let’s talk about these things called structured notes. That’s super exciting.|
|Morgan Dunn:||It is super exciting. So what are they, Radon? What are structured notes?|
|Radon Stancil:||Well, let me just say this on our discussion today is that we are going to keep this somewhat high level. And some of these things, as we explain them, would be a little bit better or easier if we were doing it visually. But we’re going to try to describe things in a way to help you visualize them. And I will say that to think about what they are, think about the title. They are a structured note, and that means that a bank is going to structure the note so that it will perform, really, for one of two categories: risk managed growth or income. The ones that Murs and I are using right now are all income-based.|
|So just to understand how they work, a bank will basically look at a couple of different elements. They’re going to look at interest rates, they’re going to look at volatility in the stock market, and they’re going to look at some indexes, which we’ll go into a little bit more a little bit later. And based on those elements, they’re going to come out and say, “Hey, we think that we could pay a certain amount of a coupon rate or interest rate over a period of time.” The beauty of these is that we are able to build them to fit whatever we want. So if we say, “I want to be guaranteed for the next six months,” well, then I’m going to make less money than if I say, “I want to be guaranteed for the next three.” So we’ll go into that in a little bit more detail. Big picture here is they’re going to be structured to either give us risk managed growth or income. And the ones that we talk about the most are income structured.|
|Morgan Dunn:||So who are they issued by?|
|Murs Tariq:||So Radon already said it, they’re issued by banks. Banks like your J.P. Morgan or your Morgan Stanley or any other major bank out there, they all have the ability to issue them. And just like when you’re picking a bank, or you’re picking an advisor, or you’re picking an insurance company that you want to work with, you want to evaluate the risk that’s going to come with that bank because they are the one that’s backing the note. And it’s not the government. A bank can’t just keep printing money like the government can. So there is some underlying risk to the bank that you choose.|
|So all the banks that we’re looking at are very highly credit rated and have a lot of deposits on them. But ultimately what we do is when we’re going to purchase a note, we are going and shopping banks. We’re going to the banks and saying, “Hey, here are my stipulations,” those structures that Radon was talking about, “here’s the different things that I want, and here’s how much money we’re going to put into this note. And what can you offer us?” And so the bank is going to come back to us with an offering based off of our criteria, but ultimately it’s the bank who’s issuing them.|
|Morgan Dunn:||So once you pick one, how do they work?|
|Radon Stancil:||Okay. So now I’m going to need you to put on some of that mind’s eye that you can see and visualize things. And I’m going to, again, not talk about a specific structured note because we could do so many things with them, but I’m just going to use general terms and general explanation. So what happens is, and I’m going to talk about… Now, again, we could go a hundred different ways on how they could be structured. I’m just going to use one of the structures because we don’t want to get bogged down into a ton of details. But here’s the way they work. We’re going to start with an underlying stocker index. We personally like to look at indexes, and we want to look at large indexes that are not super volatile. And typically, in order to dial the risk down even further, we’re going to use at least three indexes as our underlier.|
|Now, let me explain how that works. Big picture, what’s going to happen is is all three of my indexes and when I buy them are going to have a beginning start date. Once that occurs, I am now going to have a few different things that could occur. If my indexes, all three of my indexes, are negative or flat, then I am going to get a coupon payment. And let’s just for this purpose say that the coupon payment is 12%. That means every month I’m going to get a 1% coupon payment on that buy.|
|Now, there’s a couple of variables here and that is what we have which are called some barriers, and I’ll explain that a little bit more later. So these barriers work this way. If any one of those indexes are down by the barrier amount, so let’s just say it’s 30%, so I buy this in, let’s just use the S&P 500 as one of my indexes. Let’s say that that index, one of the indexes is down 30% or more from the date I buy it. I’m not going to get a coupon payment that month. I didn’t lose any money, I just didn’t get my coupon payment.|
|So, that’s one aspect of the product. The second one is my principal barrier. And my principal barrier says if any one of those indexes are down 40% or more, in this example they can vary, then on the date of the renewal of the contract, I could be down by that 40% or more. So here’s the key of the way we build them. We want to build them so that the risk of that occurring is less than 10% and that the amount of time that we hold it could be anywhere from six months to two, three years. We try to keep them on the shorter term. So again, we’re going to have a coupon payment based on the month. We’re going to have a principal barrier based on the time of the actual structured products. High level, we can go back and talk about that further.|
|Morgan Dunn:||You mentioned barriers a couple times. What do you mean when you say barrier?|
|Radon Stancil:||All right. Murs, can you go into that a little bit more and explain the barrier?|
|Murs Tariq:||Yeah. So look at the barrier as a line drawn in the sand, that if we go below this point then we’re not going to get one of two things. We’re not going to get the coupon payment. So in the example of it being a 12% coupon annualized, that means you’ll get 1% of that every single month. But if the coupon barrier has been breached, you’ve gone past that line in the sand, on the, what they say, date of valuation, so say you bought the note on January 1, and they’re looking at it on the 1st of every month, and if we’re looking at it on, say, March or April 1st and the index has breached past the coupon barrier, that means you’re not going to get that coupon just for that month. Now, the index, as we know, volatility, as we see the markets move every day, the indexes can go back above that barrier, and the next month, April or May of the next month, the first day, as long as we are back above that coupon barrier, we’re going to get that coupon for that month. So, that’s one of them.|
|The other barrier is going to be your principal protection. So these notes are providing coupon interest payments. They’re also providing a level of protection from losing principal. Not guaranteed that you’re going to not lose principal, but there is a high level that you’re going to get your principal back. Now, I was talking monthly on the coupons. On the barrier, it’s very important to understand on the principal barrier, the only way that you can lose money in this structured note is at the end of the term, not on the month but on the end of the term. So let’s say we bought it January 1 of 2022 and we are now at January 1 of 2023 and it’s a 12 month term. So we’ve been in it for one year. It doesn’t matter what the indexes do in between that one year window. All that matters is on January 1 of 2023, where are we at from a principal protection barrier? Have we pierced below that number?|
|So in Radon’s case, it was a 40% protection. As long as the worst of the indexes has not fallen more than 40%, you get your principal back. So maybe you paid $1,000 to get this note. We’re going to see that happen 90% of the time. There’s a 10% chance where we could be down past the barrier of the protection. So say we’re down 41%. Well, that means that one note will lose some of its principal. It’s going to lose about 41%, because now the barrier has been broken, we’re at the date of recognition, and it’s below. So we could lose our principal there.|
|But also realize that for a lot of this you’ve probably got some coupon payments. So you could say, “Well, man, I’m down 40% in this note,” but you actually got coupon payments all along so you’re not down a true 40%. And we can get into, how do we structure these and what’s the strategy? But ultimately what we’re doing is we’re buying small chunks and so that we are laddering and being very careful about how much we put into each of these notes. So we’re diversifying even the risk of a barrier being breached.|
|Morgan Dunn:||So what are the risks associated with the structured notes?|
|Radon Stancil:||We talked about a couple of those, but what I was going to say is is that there’s actually a couple different things that we have to keep in mind. Number one is the bank, the issuing bank, and then the second one is the barriers that we talked about. So we could actually build a structured product that was high risk. We could use a very high risk underlier, and we could try to say that we’d only want a barrier that’s 10% instead of 40%. And the more we do that, the higher our coupon rate’s going to be, but the higher the risk is going to be.|
|So what Murs and I are trying to do is when we buy these, we are trying to structure them so that the risk is less than a 10% chance on the principal barrier being breached. And that is back testing it for a long, long time. Now, the other one is the bank. So we only want to use very high quality banks to make sure that we’re not going to run into any kind of an issue there. So you take a J.P. Morgan, for example. Could there be problems? There could be. But that leads us to a question of, can I sell them? And we’ll get to that in just a couple minutes.|
|Morgan Dunn:||Well, that actually was my next question.|
|Radon Stancil:||Oh, that was your next question.|
|Murs Tariq:||So can you sell them? The answer is yes. Realize that there are some intricacies as to how it works. Do you sell them? Do you get your money back? Do you lose money? Do you make money? Ultimately, the way that these notes are structured, the bank in the background is doing some background investing in the options market and derivatives market. So if they are, it’s all going to depend on timing as to when you want to sell. If you buy it today and you want to sell it tomorrow, very likely you’re going to lose money on it because you’re committing to a term with the bank, and the bank has now created an investment around this term, and they’re buying agreements or options to these different indexes for a period of time. If you exit or if you tell the bank, “I want to exit early,” well, they will do that, but what they’re going to have to do is shop for an exiting. They’re going to pay a penalty, and ultimately they’re going to transition that penalty down to you.|
|Now, there is a possibility where the options could be what they call in the money, which means they are positive and you could actually make money on the sale. But ultimately, the moral of the story here is that you really don’t want to be buying these if you’re not going to be ready to hold it to whatever term that you’re buying. So we’re buying shorter term ones right now, anywhere between 12 to 18 months, and we’re not putting a ton of money into them either. So we’re keeping plenty of liquidity on the side so that very rarely would someone have to completely exit any of these positions.|
|Morgan Dunn:||So when would the notes get called?|
|Radon Stancil:||So let’s just talk about what that means first, getting called. Okay? So the notes that we are buying, so Murs talks about these terms, a 12 month term or an 18 month term. The likelihood that we will hold it for that whole term is highly unlikely. Why? Because likely these notes are going to get called. They work off of what we call an auto-call when the call means that the bank could actually call the note back, right? They could bring it back in and void out the note. So the way we’re buying them right now is we say we want three months that the bank cannot call it. So we buy it for three months, we’re going to get our coupon.|
|After the three months, if the least performing index is either positive or flat, that means two of them are positive, the worst one is either flat or a little bit positive, this note will automatically get called. And that means that we now are going to have to go out and buy another one. So you think about it, we’re buying notes right now with the market down. The likelihood is the market comes back up. It doesn’t have to go very far at all to say that it’s a little bit positive or flat. And so they’re going to get automatically called. So it is a lot of work on our part to have to keep these things rotating, but we are way more likely that they’re going to get called early than we’re going to hold them for the duration of the term.|
|Murs Tariq:||And to add to that, just like on the coupon, when you get your coupon, it’s based off of where the indexes are on the date, the date of valuation, on, say, January 1st, like I was doing in the example, same thing with the call. The call can only happen on the date of valuation. So, that’s what they’re looking at. And then there was one other thing that I had in my mind that I wanted to clarify, but if it comes back to me, Morgan, I’ll jump back in.|
|Morgan Dunn:||Okay. Well, I was wondering, what are the costs to buy them?|
|Murs Tariq:||So it’s an interesting story. The cost used to be pretty expensive to buy these if you go back 20, 30, 40 years ago. And the structured note world was really designed for the ultra-rich and the hedge fund world and everything like that. Now, with efficiencies that have come across trading platforms and everything like that and the ability for banks to start doing what they’re doing, the costs have come down significantly and to where it is now more available to your average investor. I told a client this today, actually. She was asking questions about the notes, and I told her, “You cannot go to J.P. Morgan yourself, really, and just buy these with a couple of thousand dollars. It takes a few million dollars to structure these deals.”|
|And so the advantage that she has working with us is that we’re working with a large group of people and millions of dollars. And so when we go to banks, they want our business, and they’re going to try to structure those in our favor because we’re not giving them a couple of thousand dollars. We’re giving them a few million dollars in each different buy. And so they want that money, which is going to give us a little bit of an advantage. But the cost has gone down tremendously and the availability has gone up very much if you’re working with the right group. So we see it as a really good tool, especially in times of volatility, especially when there’s so much uncertainty in the markets. These do have a decent level of predictability as far as what you’re going to get out of them and also what the risk is.|
|Radon Stancil:||Yeah. And I just want to say that we know that trying to describe something like this on a show, a podcast that is pretty much you listening to us talk could be difficult. So there’s a couple of things that I’m going to tell you that you can do to help you get this maybe a little bit better understanding. One is we do have a blog that is written on this very topic. You can go to our website, which is pomwealth.net/blog. And then if that’s not going to be good enough, which we don’t think it will be, so in the next little bit, our plan is the 1st of the year is that we’re going to do a webinar on this particular topic, and we’ll be able to have visuals at that point to walk you through exactly how they look. And so we’ll be coming out with information on that. Make sure you keep an eye out on our website, on our events page, and we’ll have that listed with all the information that you would need to be able to be a part of that webinar.|
|But thank you very much. We hope we have not confused you to the largest degree but at least given you some insight. I’ll close with this. The structured notes give us a nice income stream and can be structured to have very, very low risk, not correlated to the stock market. And that’s probably the biggest part of the story. So keep that in mind. Thank you very much. We hope you’ve enjoyed the Wine Down. We’ll talk to you again next Monday.|