What are Structured Notes?

Examples of Structured Notes

Below are a few examples of structured notes.

  • One Year Bond with a Call Option on CopperThree-Year Bond with a Futures Contract on Crude OilTwo-Year Bond with a Put Option on An Index3 Month Bond with a Forward on Currencies1 Year Bond with an Interest Rate Swap

Advantages of Structured Notes

Given below are a few examples of how structured notes benefits investors.

Disadvantages of Structured Notes

The points highlighted below to elucidate the disadvantages of these structured notes.

  • Credit Risk: There is no doubt that a structured note is often purchased to be held until the maturity of the bond. However, like any other debt instrumentDebt InstrumentDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more, it bears the possibility that the issuer may forfeit its obligation. Hence there arises a significant amount of credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more. The issuer may fail to make all payments on its obligation. Hence the investor would certainly be exposed to a great amount of credit risk prevalent in the particular structured note.Lack of Sufficient Liquidity: Structured notes do not trade in the secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more, unlike the equity or any embedded derivative instrument attached. Should an investor have an urgent requirement for liquidity and needs the money, he would have no other option than to sell the security to the original issuer. However, knowing that the contract binds the investor, the original issuer may take advantage of the situation and not offer a good price or money, assuming they are willing to make a good deal.Pricing being Inaccurate: More often than not, the structured notes do not tend to be traded in the market post their issuance. The prices of such products often tend to be calculated by a certain matrix, which is usually different from the net asset value. The matrix pricing is based on a comparative approach to the value of such assets; hence, the bias of the original issuer comes into play. Hence, the pricing may sometimes be inaccurate or even biased to a certain extent.Possibility of Huge Loss: As leverage tends to magnify returns, it tends to be a double-edged sword. The derivative returns may also go down south and badly lead to significant losses for the investor. Hence scrutiny and due diligence are required on the part of the investor.

Conclusion

Structured notes, a well-structured financial product, tend to give investors the benefit similar to ‘killing two birds with a single stone as they tend to get exposure to different products using a single product. They will now gain access to markets restricted to only a few well-sophisticated investors, and the common investor would not be able to gain such access.

Moreover, such products offer a great amount of customization and flexibility as the investor can choose to get into a derivative product that he is well aware of after studying the risk-return characteristics, thereby making the right choice after considering his goals and objectives.

Although such structured notes do give the investor the benefit of having to gain through leveraged returns through exposure to derivative products, there are possibilities that the underlying may perform badly, and the investor may experience a significant loss in this regard.

There is, of course, the exposure to significant credit risk if the issuer defaults. Hence it becomes of utmost importance that one carries out thorough due diligence and ensures one has a proper understanding of such products before venturing out to invest in them.

This has been a guide to what is Structured Notes and their definition. Here we discuss a few examples of structured notes and their advantages and disadvantages. You can learn more about financing from the following articles –

  • Promissory Notes DefinitionMedium-Term NotesUnderlying Asset MeaningStop-Loss Order