Structured notes are something that a lot of our clients are asking us about. We use these notes, but many people don’t know what they are, how to buy them or how they work. In our recent podcast (and in this post), we cover all the frequently asked questions we get about structured notes.
Structured Notes FAQS
What are Structured Notes?
Structured notes are created by a bank so that they perform for one of two categories:
- Risk managed growth
However, we mostly use income-based structured notes for our clients.
Banks offer structured notes based on multiple factors, such as volatility, interest rates and indexes. The bank will look at all these factors and offer a sort of discount rate to others based on these notes.
We can build these notes however we want.
For example, we can request a structured note for 3 or 6 months, and the bank will create these notes for us. Longer-term notes come with lower returns because of the inherent risk that the bank takes on.
Who Issues Structured Notes?
Banks. All major banks can issue structured notes. The bank will back the note, so they will take on the risks. We recommend looking at banks that have high ratings and strong financials.
You don’t want to use a smaller bank for structured notes because they’re bank-backed and are less financially sound than larger banks.
We can walk into a bank for a structured note and ask for a note based on our:
- Financial input
Since we tell the bank how much money we can put towards a note, they can then come back with an offer for the best note that they can provide.
How Do Structured Notes Work?
We start with an underlying stock or index to help, but for this example, let’s assume that we start with:
- Low volatility underlier
- Three main indexes
It’s important that we choose an underlier that is not volatile because the issuing bank wants to keep its risk to a minimum.
What happens is that all three indexes that you buy will have a beginning start date. A few things can occur here.
- If all 3 indexes are negative or flat, I’ll receive a coupon payment of, say, 12% (this will change).
- The coupon payment provides me with a 1% coupon payment per month
Now, let’s say that the barrier amount is down 30% and one of my indexes is down by this amount. I don’t receive a coupon payment in this case. Principal barriers also exist and let’s say that it’s -40%. If the index is down by this amount on the renewal date, I might be down 40% or more.
We build the structured notes to have a 10% risk of going into this negative balance and often have notes of 6 months to 3 years.
In this case, we have a coupon payment based on the month and a principal barrier.
It’s important to note that a structured note is a debt security that relies on the return and performance of the underlying asset.
What is a Structured Note Barrier?
A structured note barrier is this sort of line, drawn in the sand, that says if we go below this point, we don’t receive a coupon payment. This coupon payment is monthly, so you may not receive payment for one month and then receive it the next.
Principal protection also exists.
In the principal barrier, the only way that you can lose money is at the end of the term – not the month. If the index falls past the principal barrier at the end of the term, you won’t receive 100% of your principal put in the investment.
So, you can lose money in this case, but you likely earned money through coupon payments.
What are Structured Note Risks?
There are a few risks to be concerned about with using structured notes to secure your retirement:
- Issuing bank
We can structure these notes to have high or low risks. High risks have greater coupon payments, but you will have a higher risk of losing principal. We structure our clients’ notes for a 10% or less risk of losing some principal, which means fewer returns but better overall protection.
You should look at the banks, too.
Every bank has a small risk of not being able to pay the coupon, but this is unlikely when structuring your notes with larger banks.
Can You Sell a Structured Note?
Yes. You can sell these notes, but there are a lot of intricacies that go along with the sale. If you sell rapidly, you’re very likely to lose money. The bank will buy investments based on your term chosen, and if you sell early, you will receive a penalty.
Why? The bank has made commitments based on this term and selling may cause them to receive a penalty that is passed to you.
It’s better to only buy structured notes with the full intent of holding onto them for the entire term.
However, there are some cases when the notes may be worth more at the time of sale and you’ll make some money on this.
When Will Structured Notes Get Called?
“Getting called” is a term that you may not be accustomed to, but it means that the bank calls the note back and cancels the note. It’s very unlikely that the bank will allow a note to go to full maturity.
Instead, they will often exercise their right to recall the note.
When we structure our notes, we require a three-month period where the bank cannot call the note. This is a guarantee that we have those three months of being paid a coupon.
If we have one of the three underlying indexes being positive or flat, this note will automatically get called. We would then need to go back and buy another one. It is a lot of work to create these notes due to the call.
What are the Costs of Buying a Structured Note?
There was a time when structured notes were expensive to buy, but they were designed for the ultra-rich. Costs to create them have come down a lot and allow the regular person to purchase a structured note.
However, you need to work with someone with a lot of money to make these deals happen.
Banks will not work with you if you have a few thousand dollars to put into structured notes. Instead, they want to work with people who have millions of dollars. As a financial advisor, we have a large fund that stretches into the millions of dollars range because we bundle our clients’ money together to structure these deals.
In this scenario, the bank wants the money and is more than willing to work out terms beneficial for all parties.
Costs for structured notes are down and availability is up for structured notes.
We do plan to have a webinar on this topic to help walk you through how these structured notes look because it’s very difficult to explain without visuals.
However, in short, structured notes offer a nice return with minimal risk.