Structured notes: Investment option with upside potential, downside protection
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With stock market volatility likely to remain high until the COVID-19 crisis ends, many investors, including physicians, are concerned about the unpredictability of portfolios’ performance. At the same time, bank account, CD and treasury yields are near all-time lows.
In this environment, many physicians may be looking for investment options that provide some upside potential, with downside protection. In an earlier article, we discussed one such option – an equity-indexed universal life insurance policy. In this article, we discuss another option that, if implemented properly, can achieve this result – a structured note.
Structured notes basics
Structured notes are “hybrid” securities, as they combine the features of multiple different financial products into one. Issued by some of the largest banks in the world, structured notes combine bonds and additional investments to offer the features of both debt assets and investment assets. In fact, according to published studies, there is $2 trillion invested in structured notes worldwide.
Structured notes are not direct investments. They are derivatives, as their value is derived from another linked asset. The return on the note depends upon the issuer repaying the underlying bond and paying a premium based on the linked asset, less the bank’s fee.
Most structured notes generally have four common elements:
1. Maturity: Ranges from 6 months to many years. Most are 3-5 years.
2. Linked Asset: Typically, a stock, bond, exchange-traded find, index, currency or commodity.
3. Payoff: Amount the investor gets at maturity.
4. Protection: Level of protection the investor gets if the linked asset loses value.
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, called “the participation rate,” of the underlying asset’s price appreciation.
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. Protection is offered for both the principal and the coupon payments.
These are just a few of the most common growth notes:
- Principal-protected notes are designed to protect the investor’s principal, regardless of the performance of the underlying asset.
- Buffered notes provide some downside protection, but not total protection. For example, in a buffered note tied to the S&P 500 with a 10% buffer, if the index is down 10%, the investor gets the principal returned; if it is down farther, the investor loses 1% for each additional 1% decline in the index. In other words, if the index was down 18%, the investor’s loss would be 8%.
- Return enhanced notes provide some form of leverage to returns on the upside. For example, if the S&P 500 is positive 20% in 4 years and the note provides for 1.5 times leverage, the investor’s actual return would be 30% better than the 20% even after counting the roughly 7% of lost dividends.
- Market-linked CDs (certificates of deposit) provide FDIC insurance up to applicable amounts as well as potentially enhanced performance based on an asset class or underlying index. That performance is typically limited by participation rates and/or caps.
The common benefit of all types of structured notes is their potential for upside, with downside protection.
Case study: Physician Phil
Physician Phil invests $100,000 into a structured note offered by Big Bank. The note is tied to the S&P 500 equity index with a 30% buffered protection level and a term of 3 years. By investing in this product, Phil will get the following payoff in 3 years:
- If the S&P 500 is positive over the 3-year period, Phil will get the $100,000 back, plus the growth based on the S&P 500, less Big Bank’s fee. In this way, Phil enjoys the upside of the note.
- If the S&P 500 is negative over the 3-year period, but not below the 30% buffered downside protection (ie, down between 0%-30%), Phil will get the full $100,000 back, less the Bank’s fee. In this way, Phil benefits from the downside protection of the note.
- If the S&P 500 is more than 30% negative over the 3-year period, Phil’s payoff will be subject to the downside of the index beyond 30%. For example, if the index is down 40% at the maturity of the note, Phil will lose 10% on his initial investment, plus the bank’s fee.
Structured note risks
A number of risks are inherent in a structured note investment, including:
Complexity: Structured notes are complex financial instruments. Investors should understand the reference assets or indices and determine how the note’s payoff structure incorporates them in calculating the note’s performance.
Market risk: While some notes have buffers and other protection factors built in to reduce the impact of a bad market, the investor may still suffer a financial loss as with any other investment that is not FDIC-insured or principal-protected.
Lack of liquidity: Should investors need access to the funds in a structured note prior to maturity, they will be forced to sell the note on the open market. While there may be a buyer willing to purchase it at some price, typically it is at a deep discount to what the note is worth.
Issuer risk: Ultimately, the structured note is only as strong as the issuer. If the issuer defaults, the entire principal could be lost.
Bottom line: Work with the right advisor
Structured notes can be valuable components of a physician’s overall portfolio, especially for investors looking for downside protection with upside potential. Because these products are complex and contain inherent risks, working with a knowledgeable professional advisor to evaluate options is always recommended.
References:
https://markets.businessinsider.com/news/stocks/structured-notes-1028738479
Wealth Planning for the Modern Physician: Residency to Retirement and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at mandell@ojmgroup.com or 877-656-4362.
Bob Peelman is a partner and director of Wealth Advisors. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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