Structured notes: An investment option with upside potential and downside protection
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With stock market volatility likely to remain high until the COVID-19 crisis ends, many investors have become more risk averse. At the same time, bank account, certificate of deposit and treasury yields are nearing all-time lows.
In this environment, many orthopedic surgeons may be looking for investment options that provide some upside potential with downside protection. In this article, we briefly discuss one option that, if implemented properly, can achieve this result — a structured note.
Structured notes basics
Structured notes are “hybrid” securities because these 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 provide the features of both debt assets and investment assets. In fact, according to published studies, $2 trillion are invested in structured notes worldwide.
Structured notes are not direct investments; structured notes 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.
Structured notes commonly have the following four elements:
- maturity that can range from 6 months to several years, but is usually 3 years to 5 years;
- a linked asset that is typically a stock, bond, exchange traded fund, index, currency or commodity;
- payoff, which is the amount the investor gets at maturity; and
- a level of protection for the investor if the linked asset loses value.
Types of structured notes
There are a variety of structured notes that provide investors with diverse options and a range of risk/return profiles. The common benefit of all types of structured notes is the potential for upside with downside protection. Beyond that, structured notes generally fall into one of two broad categories: growth notes and income notes.
With growth notes, investors receive a percentage of the underlying asset’s price appreciation, which is called “the participation rate.”
For income notes, during the life of the note, 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 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.
There are a number of common growth notes that include the following:
- 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 Standard & Poor’s 500 Index with a 10% buffer, if the index is down 10% the investor gets the principal returned. If the S&P 500 is down farther, they only lose 1% for each additional 1% decline in the index. In other words, if the index was down 18%, the investor’s loss would be only 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%, which is better than the 20% even after counting the roughly 7% of lost dividends; and
- Market-linked 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.
Case study: Orthopedist Oscar
Orthopedist Oscar invests $100,000 in 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, Oscar will get the following payoff in 3 years:
If the S&P 500 is positive during the 3-year period, Oscar will get the $100,000 investment back, plus the growth based on the S&P 500, less Big Bank’s fee. In this way, Oscar enjoys the upside of the note.
If the S&P 500 is negative during the 3-year period, but not below the 30% buffered downside protection (ie, down between 0% and 30%), Oscar will get the full $100,000 back, less Big Bank’s fee. In this way, Oscar benefits from the downside protection of the note.
If the S&P 500 is more than 30% negative during the 3-year period, Oscar’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, Oscar will lose only 10% on his initial investment (plus Big Bank’s fee). Oscar partly benefits from the downside protection of the note.
Structured note risks
A number of risks are inherent in a structured note investment, including the following:
- Complexity. Structured notes are complex financial instruments. Investors should understand the reference asset(s) or index(es) and determine how the note’s payoff structure incorporates these when calculating the note’s performance;
- Market risk. Although some notes have built-in buffers and other protection factors 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 an investor need access to the funds in a structured note prior to maturity, the investor will be forced to sell the note on the open market. Although there may be a buyer willing to purchase it at some price, typically it is at a deep discount vs. what the note is worth; and
- Issuer risk. Ultimately, the structured note is only as strong as the issuer. If the issuer defaults, the entire principal could be lost.
Structured notes can be valuable components of an orthopedist’s overall portfolio, especially for investors who seek downside protection with upside potential. These products are complex and contain inherent risks. Working with a knowledgeable professional advisor to evaluate options is recommended.
- Reference:
- Wealth Protection Planning for Orthopaedic Surgeons and the newly published Wealth Planning for the Modern Physician: Residency to Retirement are available free in print or by e-book download. Text OT20 to 555-888. Go to www.ojmbookstore.com. Enter code OT20.
- For more information:
- Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Illinois. He can be reached at email: sanjeevbhatia1@gmail.com.
- David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. 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.
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