Structured Notes: The Secret to Improving Your Risk/Return Profile?

Structured notes are gaining momentum in the market, with a whopping $2 trillion in assets under management (AUM) globally.

So why haven’t more investors heard of them?

Traditionally, structured notes had a $1 million minimum investment. They were only available to high-net-worth or institutional investors—but they are now becoming more accessible.

Today’s infographic from Halo Investing explains what structured notes are, outlines the two main types, and demonstrates how to implement them in a portfolio.

What is a Structured Note?

A structured note is a hybrid security, where approximately 80% is a bond component and 20% is an embedded derivative.

Structured notes are issued by major financial institutions. Since they are the liability of the issuer, it is critical that the investor is comfortable with the issuer—as with any bond purchase.

Almost all structured notes have four simple parameters.

1. Maturity – The term typically falls within 3 to 5 years.
2. Payoff – The amount the investor receives at maturity.
3. Underlying asset – The note’s performance is linked to the price return (excluding dividends) of an asset, such as stocks, ETFs, or foreign currencies.
4. Protection – The level of protection the investor receives if the underlying asset loses value.

As long as the underlying asset does not fall lower than the protection amount at maturity, the investor will receive their initial investment back in full.

This is the primary draw of structured notes: they provide a level of downside protection, while still allowing investors to participate in market upswings.

Types of Structured Notes

There are a variety of structured notes, providing investors with diverse options and a range of risk/return profiles. Structured notes generally fall into one of two broad categories: growth notes and income notes.

Growth Notes

Investors receive a percentage—referred to as the participation rate—of the underlying asset’s price appreciation.

For example, a growth note has the following terms:

• Maturity: 5 years
• Participation rate: 117%
• Underlying asset: S&P 500 index
• Principal protection: 30%

Here’s what the payoff would look like in 4 different scenarios:

Income Notes

Over an income note’s life, investors receive a fixed payment known as a coupon. Income notes do not participate in the upside returns the way a growth note does—but they may generate a higher income stream than a standard debt security or dividend-paying stock.

This is because protection is offered for both the principal and the coupon payments. For example, say a note’s underlying asset is the S&P 500, and it pays an 8% coupon with 30% principal protection. If the S&P 500 trades sideways all year—sometimes slightly negative or positive—the note will still pay its 8% coupon due to the protection.

Income notes have another big advantage: their yields can spike in tumultuous markets, as was demonstrated during the market volatility near the end of 2018.

Why did this spike occur? Banks construct the derivative piece of an income note by selling options*, which are more expensive in volatile markets. Banks then collect these higher premiums, creating larger coupons inside the structured note.

Investors can diversify their return profile by using a combination of growth and income notes.

*Option contracts offer the buyer the opportunity to either buy or sell the underlying asset at a stated price within a specific timeframe. Unlike futures, the buyer is not forced to exercise the contract if they choose not to.

Portfolio Applications

Structured notes are powerful tools that can accomplish almost any investment goal, and investors commonly use them as a core portfolio component.

• Step 1: Select a portfolio asset class where downside protection is desired.
• Step 2: Reallocate a portion of the asset class to a structured note
• Step 3: Improve risk/reward performance.

The asset class will demonstrate an enhanced return profile, with less downside risk.

A Global Market

While relatively small in the Americas, the structured notes market is growing on a global scale:

In the first half of 2019, assets under management in the Americas was up by 4%. It’s clear the asset class presents enormous untapped potential—and investors are taking notice.

Lowering Barriers Through Technology

Technology is becoming more ingrained in wealth management—empowering investors to access structured notes more easily through efficient trading.

The market is already becoming more accessible. By 31 October 2019, the average transaction size had decreased by almost $500,000 over the year prior.

Technology also offers other benefits for investors:

• Improved analytics
• Investment education
• Risk information
• Increased competition = lower fees
• Improved secondary liquidity

As more investors take advantage of this asset class, they may be able to improve their return potential while limiting their risk.

The History of Interest Rates Over 670 Years

Today, we live in a low-interest-rate environment, where the cost of borrowing for governments and institutions is lower than the historical average. It is easy to see that interest rates are at generational lows, but did you know that they are also at 670-year lows?

This week’s chart outlines the interest rates attached to loans dating back to the 1350s. Take a look at the diminishing history of the cost of debt—money has never been cheaper for governments to borrow than it is today.

The Birth of an Investing Class

Trade brought many good ideas to Europe, while helping spur the Renaissance and the development of the money economy.

Key European ports and trading nations, such as the Republic of Genoa or the Netherlands during the Renaissance period, help provide a good indication of the cost of borrowing in the early history of interest rates.

The Republic of Genoa: 4-5 year Lending Rate

Genoa became a junior associate of the Spanish Empire, with Genovese bankers financing many of the Spanish crown’s foreign endeavors.

Genovese bankers provided the Spanish royal family with credit and regular income. The Spanish crown also converted unreliable shipments of New World silver into capital for further ventures through bankers in Genoa.

Dutch Perpetual Bonds

A perpetual bond is a bond with no maturity date. Investors can treat this type of bond as an equity, not as debt. Issuers pay a coupon on perpetual bonds forever, and do not have to redeem the principal—much like the dividend from a blue-chip company.

By 1640, there was so much confidence in Holland’s public debt, that it made the refinancing of outstanding debt with a much lower interest rate of 5% possible.

Dutch provincial and municipal borrowers issued three types of debt:

1. Promissory notes (Obligatiën): Short-term debt, in the form of bearer bonds, that was readily negotiable
2. Redeemable bonds (Losrenten): Paid an annual interest to the holder, whose name appeared in a public-debt ledger until the loan was paid off
3. Life annuities (Lijfrenten): Paid interest during the life of the buyer, where death cancels the principal

Unlike other countries where private bankers issued public debt, Holland dealt directly with prospective bondholders. They issued many bonds of small coupons that attracted small savers, like craftsmen and often women.

Rule Britannia: British Consols

In 1752, the British government converted all its outstanding debt into one bond, the Consolidated 3.5% Annuities, in order to reduce the interest rate it paid. Five years later, the annual interest rate on the stock dropped to 3%, adjusting the stock as Consolidated 3% Annuities.

The coupon rate remained at 3% until 1888, when the finance minister converted the Consolidated 3% Annuities, along with Reduced 3% Annuities (1752) and New 3% Annuities (1855), into a new bond─the 2.75% Consolidated Stock. The interest rate was further reduced to 2.5% in 1903.

Interest rates briefly went back up in 1927 when Winston Churchill issued a new government stock, the 4% Consols, as a partial refinancing of WWI war bonds.

American Ascendancy: The U.S. Treasury Notes

The United States Congress passed an act in 1870 authorizing three separate consol issues with redemption privileges after 10, 15, and 30 years. This was the beginning of what became known as Treasury Bills, the modern benchmark for interest rates.

The Great Inflation of the 1970s

In the 1970s, the global stock market was a mess. Over an 18-month period, the market lost 40% of its value. For close to a decade, few people wanted to invest in public markets. Economic growth was weak, resulting in double-digit unemployment rates.

The low interest policies of the Federal Reserve in the early ‘70s encouraged full employment, but also caused high inflation. Under new leadership, the central bank would later reverse its policies, raising interest rates to 20% in an effort to reset capitalism and encourage investment.

Looking Forward: Cheap Money

Since then, interest rates set by government debt have been rapidly declining, while the global economy has rapidly expanded. Further, financial crises have driven interest rates to just above zero in order to spur spending and investment.

It is clear that the arc of lending bends towards ever-decreasing interest rates, but how low can they go?