Structured notes; pros and cons

Structured notes are complicated, but widely sold, investments in the expat market. This article will example these investments in more detail.

What are structured notes?

A structured note is a financial derivative that tracks certain assets. They claim to be able to protect investors from the downside of markets.

They typically track numerous asset classes for a period of time and have something called a protection barrier and coupon trigger or investment yield.

For example, a structured note could track 4 indexes. In this case let’s give an example of the UK FTSE 100, the US S&P 500 Index, the Japanese Nikkei and the Shanghai Composite Exchange.

The note may last for 5 years, from 2019, until 2024. The notes pay out 2% quarterly (this is the coupon trigger or the investment yield), so 8% per year.

However, the investor only gets this quarterly payment, if the investments don’t fall below 20% of their original value.

If any of the investments within the note fall below 20% during the 3 month period, the investor doesn’t get the payment, even if the other 3-4 assets have risen in value!

The note is also protected, up to a point. So, in this case, the client gets their money back, at the end of the 5 years, provided the markets don’t fall by more than 35%.

In many cases, if even 1 of the 4 or 5 underlying investments falls below the 35% barrier at matruity, the investor can lose a lot of money.

The above is one example (in this case based on indexes) of how structured notes are used. Many other notes track individual stocks, commodities and other assets.

They are all based on the same principles though. Downside protection and the chance to make yields.

What’s not to like? Provided markets don’t fall more than 35%, you don’t lose money AND you will get many 2% quarterly payments?

Well it isn’t that simple. This article will explain this in more detail.

What are some of the negatives of structured notes?

The above example shows how complicated structured notes are. You should also be wary of complexity, as opposed to simplicity.

Many structured notes may have a 35% protection barrier, but remember that still has a significant currency risk, especially as it only requires 1 asset to fall significantly.

Take the last 5 years as an example. The FTSE stock market didn’t fall by 30% after Brexit in British Pound terms, but did in US Dollar terms.

In fact, many currencies have fallen by 20%-30% in USD terms in the last 5 years . So all of a sudden, that 35% protection barrier doesn’t seem safe.

All you need is a 15%-20% devaluation + a 15%-20% falls in the stock market to breach the barrier, or indeed a 35.1% currency depreciation and 0% stock market growth.

In addition to that, structured notes have the following negatives;

  1. They don’t pay dividends. This is huge. As per the chart below, dividends have historically accounted for a huge part of the S&P’s historical performance:

2. Liquidity. It isn’t easy to sell structured notes early, unlike liquid funds.

3. Hidden costs. A lot of structured notes have hidden costs, and indeed, hidden risks.

4. They can completely fail. If the issuing bank fails, an investor could lose all of their money. A guarantee is only as good as the guarantor’s ability to keep to their promises.

Let us not forget that Lehman Brothers produced a lot of guaranteed products and notes.

So in the same way that a debt promise made by the US Government is worth more than the Zimbabwean Government, which is why US Treasury Bills pay so little interest compared to emerging market debt, this risk level varies.

A structured note issued by Goldman Sachs or HSBC, is worth more than one offered by a tiny boutique bank in a developing country, without proper regulation.

In comparison, an investment like an index fund can’t completely fail, unless there is a nuclear war and stock markets no longer exist……

5. The assets that are typically picked, within this note, can cause losses. To give the structured notes their price, 1 of the assets from the 4-5 assets, tends to be riskier. This significantly increases the chances of missing coupon triggers and maturity payments.

Remember if your note is based on the aforementioned 4 assets, you could lose money even if 3 of the markets have increased in price by 50%, by one has fallen by 35.1%.

6. Markets like the US S&P have historically given 10% returns. Granted, this is merely a long-term average.

Between 1985 and 1999, and 2009-2017, markets have exceeded those averages. Likewise, from 2000 until 2009, markets didn’t meet these averages.

Nevertheless, you have to remember that getting 7%-8% sounds good, but in reality is below market returns.

If you miss some of the quarterly payments, you could end up with 5% or less, for taking huge risk.

I am not suggesting that 100% of structured notes are awful. Some are riskier than others.

Some very sophisticated investors have used them well. If they are 5% of your total wealth, you probably aren’t going to have many products.

In general, however, there are more sensible ways to manage your risk than this. Being long-term (time in the market as opposed to timing the market) and having a greater government bond exposure, are all tried and tested ways to manage market risk.

So why are structured notes popular?

There are two reasons. The banks and some other financial institutions can make a lot of money from these notes.

They are, therefore, aggressively sold by some institutions. Secondly, they have a captive audience with some investors.

Because losses are more painful than gains are pleasurable, many investors don’t want to invest in the stock markets at all.

This isn’t sensible, because long-term, stocks have always gone up in a big way. Many new and inexperienced investors, are sold the idea that they can have their cake and eat it.

Get 70%-80% of the potential market gain, whilst having downside protection. In reality, there is no such thing as a free lunch.

Where are structured notes typically sold?

They are widely sold in the expat markets, within lump sum products, as the article below explains in more depth. They are also sold in other onshore markets, focused on the local populations.

Conclusion: are structured notes a good investment?

In general, no they aren’t. Those that have them in their portfolio, should consider an alternative investment, once the investment has ended.

One Reply to “Structured notes; pros and cons”

Leave a Reply

Your email address will not be published. Required fields are marked *