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.
- Maturity – The term typically falls within 3 to 5 years.
- Payoff – The amount the investor receives at maturity.
- Underlying asset – The note’s performance is linked to the price return (excluding dividends) of an asset, such as stocks, ETFs, or foreign currencies.
- 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.
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:
|S&P 500 return||Growth Note Return|
The S&P 500 can return a loss of up to 30%, the principal protection level in this example, before the note starts to lose value.
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.
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:
|Region||AUM (2019 Q2)|
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
Interest rates sit near generational lows — is this the new normal, or has it been the trend all along? We show a history of interest rates in this graphic.
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:
- Promissory notes (Obligatiën): Short-term debt, in the form of bearer bonds, that was readily negotiable
- Redeemable bonds (Losrenten): Paid an annual interest to the holder, whose name appeared in a public-debt ledger until the loan was paid off
- 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?
Sustainable Investing: Debunking 5 Common Myths
Do sustainable strategies underperform conventional ones? This infographic shines a light on the realities of sustainable investing and the ESG framework.
Sustainable Investing: Debunking 5 Common Myths
It began as a niche desire. Originally, sustainable investing was confined to a subset of investors who wanted their investments to match their values. In recent years, the strategy has grown dramatically: sustainable assets totaled $12 trillion in 2018.
This represents a 38% increase over 2016, with many investors now considering environmental, social, and governance (ESG) factors alongside traditional financial analysis.
Despite the strategy’s growth, lingering misconceptions remain. In today’s infographic from New York Life Investments, we address the five key myths of sustainable investing and shine a light on the realities.
|Sustainable strategies underperform conventional strategies||Sustainable strategies historically match or outperform conventional strategies|
In 2015, academics analyzed more than 2,000 studies—and found that in roughly 90% of the studies, companies with strong ESG profiles had equal or better financial performance than their non-ESG counterparts.
A recent ranking of the 100 most sustainable corporations found similar results. Between February 2005 and August 2018, the Global 100 Index made a net investment return of 127.35%, compared to 118.27% for the MSCI All Country World Index (ACWI).
The Global 100 companies show that doing what is good for the world can also be good for financial performance.
—Toby Heaps, CEO of Corporate Knights
|Sustainable investing only involves screening out “sin” stocks||Positive approaches that integrate sustainability factors are gaining traction|
In modern investing, exclusionary or “screens-based” approaches do play a large role—and tend to avoid stocks or bonds of companies in the following “sin” categories:
However, investment managers are increasingly taking an inclusive approach to sustainability, integrating ESG factors throughout the investment process. ESG integration strategies now total $17.5 trillion in global assets, a 69% increase over the past two years.
|Sustainable investing is a passing fad||Sustainable investing has been around for decades and continues to grow
Over the past decade, sustainable strategies have shown both strong AUM growth and positive asset flows. ESG funds attracted record net flows of nearly $5.5 billion in 2018 despite unfavorable market conditions, and continue to demonstrate strong growth in 2019.
Not only that, the number of sustainable offerings has increased as well. In 2018, Morningstar recognized 351 sustainable funds—a 50% increase over the prior year.
|Interest in sustainable investing is mostly confined to millennials and women||There is widespread interest in sustainable strategies, with institutional investors leading the way|
Millennials are more likely to factor in sustainability concerns than previous generations. However, institutional investors have adopted sustainable investments more than any other group—accounting for nearly 75% of the managed assets that follow an ESG approach.
In addition, over half of surveyed consumers are “values-driven”, having taken one or more of the following actions with sustainability in mind:
- Boycotted a brand
- Sold shares of a company
- Changed the types of products they used
Women and men are almost equally likely to be motivated by sustainable values, and half of “values-driven” consumers are open to ESG investing.
5. Asset Classes
|Sustainable investing only works for equities||Sustainable strategies are offered across asset classes|
This myth has a basis in history, but other asset classes are increasingly incorporating ESG analysis. For instance, 36% of today’s sustainable investments are in fixed income.
While the number of sustainable equity investments remained unchanged from 2017-2018, fixed-income and alternative assets showed remarkable growth over the same period.
Tapping into the Potential of Sustainable Investing
It’s clear that sustainable investing is not just a buzzword. Instead, this strategy is integral to many portfolios.
By staying informed, advisors and individual investors can take advantage of this growing strategy—and improve both their impact and return potential.
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