To the ordinary investor, structured notes seem to make perfect sense. 澳洲幸运5开奖号码历史查询:Investment banks advertise structured notes as the ideal vehicle to help you benefit from excellent stock market performance while simultaneously protecting you from bad 澳洲幸运5开奖号码历史查询:market performance.

Who wouldn’t want upside potential with 澳洲幸运5开奖号码历史查询:downside protection? However, investment banks (which are, to some extent, sales and marketing machines that focus on promoting their investment products) may not reveal that the cost of that protection can often outweigh the benefits. But that’s not the only 澳洲幸运5开奖号码历史查询:investment risk you’re taking on with structured notes.

Let’s take a closer look at these investments.

What Is a Structured Note?

A 澳洲幸运5开奖号码历史查询:structured note is a debt obligation—basically like an IOU from the issuing investment bank—with an embedded 澳洲幸运5开奖号码历史查询:derivative component. In other words, it invests in assets via derivative instruments. A five-year bond with an options contract is an example of one ki🌱nd💎 of structured note.

A structured note can track a basket of equities, a single stock, an 澳洲幸运5开奖号码历史查询:equity index, commodities, currencies, interest rates, and more. For example, you can have a structured note deriving its performance from the 澳洲幸运5开奖号码历史查询:S&P 500 Index, the S&P Emerging Markets Core Index, or both. The combinations are almost limitless, as long as they fit the concept: to benefit from the asset’s upside potential while als🎶o lim♏iting exposure to its downside.

What Are the Advantages of Structured Notes?

Investment banks advertise that structured notes allow you to diversify specific 澳洲幸运5开奖号码历史查询:investment products and security types in addition to providing overall asset 澳洲幸运5开奖号码历史查询:diversification. However, there can be such a thing as over-diversification, whereby overall returns can be negatively impacted. It is important to understand how a particular structured note achieves diversification. For example, is there a high degree of correlation 💛between assets held in the note?

Investment banks also often advertise that structured notes allow you to access asset classes that are either only available to institutions or hard for the average investor to access. But in today’s investing environment, it’s easy to invest in almost anything via 澳洲幸运5开奖号码历史查询:mutual funds, 澳洲幸运5开奖号码历史查询:exchange-traded funds (ETFs), 澳洲幸运5开奖号码历史查询:exchange-traded notes (ETNs), and more. Besides t🅷hat, do you think investing in a complex package of derivatives (structured notes) is consid🍬ered easy to access?

The only benefit that makes sense is that structured notes can have customized payouts and exposures. Some notes advertise an investment return with little or no 澳洲幸运5开奖号码历史查询:principal risk. Other notes offer a high return in 澳洲幸运5开奖号码历史查询:range-bound markets with or without principal protections. Still, other notes tout alternatives for generating higher yields in a low-return environment. Whatever your fancyℱ, derivatives allow structured notes to align with any particular market or economic forecast.

Additionally, the inherent leverage allows for the derivative’s returns being higher or lower than its 澳洲幸运5开奖号码历史查询:underlying asset. Of course, there must be tradeoffs, since adding a benefit in one place must decrease the benefit somewhere else. As you no🀅 doubt know, there is no such thin💦g as a free lunch.

What Are the Disadvantages of Structured Notes?

Credit Risk

If you invest in a structured note, then you have the intention of holding it to maturity. That sounds good in theory, but did you research the 澳洲幸运5开奖号码历史查询:creditworthiness of the note’s issuer? As with any IOU, loan, or other types of debt, you bear the risk that the issuing investment bank might get into trouble and f🍃orfeit its obligation. 

If that happens, the underlying derivatives can have a positive return, and the notes could still be worthless—which is exactly what happened to investors in 2008 during 澳洲幸运5开奖号码历🌟史查询:the collapse of Lehman Brothers structured notes. A structured note adds a layer of 澳洲幸运5开奖号码历史查询:credit risk on top of 澳洲幸运5开奖号码历史查询:market risk. And never assume that just because the bank is a big name, the risk doesn’t exist.

Lack of Liquidity

Structured notes rarely trade on the 澳洲幸运5开奖号码历史查询:secondary market after issuance, which means they are highly illiquid. If you need to get out for any personal reason or because the market is crashing, your only option for an early exit is to sell to the origin💧al issuer.

Inaccurate Pricing

Since structured notes don’t trade after issuance, the odds of accurate daily pricing may be low. Prices are usually calculated by a matrix, which is very different from 澳洲幸运5开奖号码历史查询:net asset value. Matrix p🍸ricing is essentially a best-guess approach. And the original issuer does the guessing.

Other Risks You Need to Know

澳洲幸运5开奖号码历史查询:Call risk is another factor that many investors overlook. For some structured notes, it’s possible for the issuer to redeem the note before maturity, regardless of the price. This means it’s possible that an investor will bꦦe forced to receive a price that’s wellꦅ below face value.

The risks don’t end there. You also have to consider the tax factor. Investors may be responsible for paying federal taxes on structured notes, even if the note hasn’t reached maturity and the investor has not received any cash. Also, when sold, the proceeds may be taxed at the 澳洲幸运5开奖号码历史查询:ordinary income rate, rather than at the more favorable 澳洲幸运5开奖号码历史查询:capital gains rate. Each offering is different, and the U.S. Securities and Exchange Commission (SEC) advises investors to carefully read the 澳洲幸运5开奖号码历史查询:prospectus of a structured product to understand the tax implications.

As far as price goes, you will likely overpay for a structured note, which relates to the issuer’s costs for selling, structuring, and hedging.

Example of a Principal-Protected Note (PPN)

There are various different forms of structured notes. Let’s take a look at how one of the most coveted types, the 澳洲幸运5开奖号码历史查询:principal-protected note (PPN), works.

PPNs are advertised as very sa🌃fe as they, in theory, come with no downside risk. The return of the initial investment is guaranteed by the issuer, on top of any gains. In reality, PPNs are not♒ risk-free at all.

PPNs are exposed to credit risk, meaning y𒊎ou get zero if the issuer goes bust, and they often carry caps that take a lot of the shine off the assumed benefits.

Let’s look at a hypothetical example of an 18-month structured note with principal protection linked to the returns of the S&P 500. Based on how it’s ad💧vertised, investors may think that if the index rallies 50% over the period, they’ll pocket all the gains, and if the index dips in value, they’ꦯll get back what they invested. But that is not usually the case.

�𓃲� First, there are the fees to consider, which eat into returns. Second, there are usually various conditions attached.

Caps: Read the Small Print

In the small print, you’ll learn more about what the note actually offers. For example, the prospectus might state that the index cannot fall by more than 25%. That means if it does, your principal is no longer protected. Downside protection can be called a barrier or buffer. A barrier implies that you’ll lose everything if the index moves below the specified level. A buffer, on the other hand, means anything over the threshold will be forfeited. So, using the example above, if the index was down 50%, then the note would be down 25%.

Gains can be capped, too.𒅌 The prospectus may state that if the index rises by more than 25%, you’ll only get the principal back and forgo any gains.

No Dividends

Another major downside is that dividend payments aren’t included. If you were investing directly in the S&P 500 via a mutual fund or ETF, you would be 澳洲幸运5开奖号码历史查询:reinvesting t꧑hose dividends over the𝓀 18 months. This is a huge deal.

For example, in 2021, the S&P 500 generated a total return, including dividends, of 28.41%. Strip out the dividends being reinvested, and that return falls to 26.61%. That’s quite a difference and can really add up over time, impacting gains and downside protection on notes with barriers and buffers.

The Bottom Line

澳洲幸运5开奖号码历史查询:Structured notes are complicated and may not be a suitable investment strategy for the average individual investor. The 澳洲幸运5开奖号码历史查询:risk/reward ratio can often be simply too poor. ඣThe illustrations and examples provided by investment banks tend to highlight the best features while downplaying the limitations and disadvantages. The truth is that on a historical basis, the downside protection of these notes is limited, and at the same time, the upside potential is capped. In addition, consider the fact that there are no dividends to help ease the pain of a decline.

If you choose structured noℱtes anyway, be sure to investigate fees and costs, estimated value,🍃 maturity, whether or not there is a call feature, the payoff structure, tax implications, and the creditworthiness of the issuer.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.