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Why Structured Notes Might Be a Fit for Some Clients

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What You Need to Know

  • A structured note consists of a bond and one or more options.
  • Structured notes can provide unique exposure that's not available through investments like mutual funds or ETFs.
  • A default by the issuing bank would severely reduce the value of each note, as they are unsecured debts.

Structured products have the connotation of institutional or off-the-grid usage for most investment advisors. However, we’ve utilized structured notes as a complement to long-only mutual funds and exchange-traded funds in client portfolios for years.

During the financial crisis, we used them as a “repair and recovery” strategy in an attempt to recoup the losses that occurred in the fall of 2008. Currently, we use them as a hedge within our clients’ portfolios. Structured notes can be used to offer hedged or leveraged exposure depending on your viewpoint.

But let’s start with the basics:

What are structured notes?

These products are extremely flexible investment vehicles that can be used by investors and advisors in a variety of ways. They can be used as an income replacement vehicle, to hedge a portfolio or to provide unique exposure that is not available in traditional investments such as mutual funds or ETFs.

How long have structured notes been in existence?

We’ve been using structured notes since 2008, but they have been around much longer and have been widely used for decades in Europe and Asia where investors are more risk averse. One reason why they are more widely used in Europe is that business schools in Europe teach options-based strategies as part of their curriculum.

What variables are involved in a structured note?

Tenor (duration) of the note, downside protection (buffer or barrier), upside participation (leveraged or unleveraged), underlying product (stock, index, ETF or other investment) and size (notional amount) of the trade are variables involved in each note.

Advisors need to have a view of the stock market or individual security before requesting pricing of a note. Are you bullish or bearish? Typically, you need to have a viewpoint before selecting an appropriate structured note to utilize within a client’s portfolio.

How is a structured note created?

Structured notes contain essentially two components: a bond and a single or multiple option(s). The bond portion of the structured note serves as collateral for the trade. The option portion can be linked to a stock, index or ETF.

The simplest structured note available is a principal protected note that consists of a zero-coupon bond and an option tied to an index such as the S&P 500. If the stock market declines, you will receive your principal back but will need to pay some original issue discount (OID) on the zero-coupon bond. If the index rises, you will participate to some degree in the gains. Structured notes are created by investment firms and multinational banks.

How can I purchase a structured note?

Investors can purchase structured notes directly from their broker-dealer or custodian via monthly offerings, or through a platform, such as Halo Investing. In addition, custom notes can be created at values as low as $500,000.

Since notes can be broken down into $1,000 increments, our firm typically creates customized structured notes with a value between $2 million to $3 million and then allocate across various client accounts depending on their asset allocation and portfolio size.

What advice can we give to new users of structured notes?

We would recommend a reverse inquiry process for folks interested in purchasing a structured note for their clients. This process consists of providing a number of banks with four of the five possible variables and then having the banks provide quotes on the remaining variable.

Typically, we provide banks with the underlying investment (e.g. S&P 500), tenor, downside protection (20% buffer), upside leverage and then have them solve for the upside cap or maximum return.

Also, we typically only have 12-20 notes across all of our clients’ portfolios. If you decide to purchase monthly offerings, will you be able to appropriately monitor these investments across each of your clients’ portfolios?

We limit our total number of structured notes to closely monitor their performance via a biweekly update of an Excel matrix that helps us to determine whether we need to hold or roll (sell and reinvest) each structured note.

What could go wrong?

Because notes are senior unsecured debts of the issuing bank, a default by the issuing bank would severely reduce the value of each note.

Folks often cite Lehman Brothers as an example of what could go wrong with structured notes. Following the Lehman debacle, the government rewrote the laws and the final two remaining investment banks (Morgan Stanley and Goldman Sachs) became bank holding companies, which would allow them access to the Federal Reserve in times of financial stress.

While this does not completely eliminate the possibility of default, it certainly reduces this particular risk to investors.

Where can an advisor seek more information regarding structured notes?

You can reach out to groups such as Halo Investing, Axio, InCapital, FirstTrust, and all of the major banks (Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, etc.) for more information regarding these investments.

Thomas W. Balcom, CFP, CAIA, is founder and head of 1650 Wealth Management, an RIA that is a power user of structured notes, which currently account for 50% of the firm’s client portfolios. The firm is located in Lauderdale-by-the-Sea, Florida.

To hear Tom Balcom and other experts on this topic, please listen to: Beyond Markowitz: Personalizing Your Practice and Client Experience with Structured Investments.