Structured notes are issued by major financial institutions and may offer substantially more yield than other bond alternatives or other cash equivalents. They bear the credit risk of the financial institution that has issued them and are fully taxable at the federal, state and local level.
In order to meet the demands of many of their customers who have grown tired of persistently low rates on cash investments, many investment banks began offering structured investments to their clients through their brokers during the second half of 2010. These structured notes are created synthetically by the bank and offer depositors/clients the ability to receive rates of return well above the risk free rate, provided certain conditions are met. The bank then hedges around these instruments (selling puts and calls) in order to reduce the bank's own exposure. These instruments bear extreme risks, including the risk of the loss of principal, and should not be viewed as an alternative to cash holdings. They, however, may represent an effective way of earning income in the current low-return environment for those investors comfortable with the associated risks.
In their most simple forms, these notes can generally be organized into at least three basic categories - step-up notes, single range notes, and fixed-rate knock-out notes. Below is an example for each prevailing variation of a recent offering:
This is a note which provides the holder with a fixed interest rate for a period, followed by a series of additional periods with differing fixed rates. These notes are usually callable.
Example: A financial institution issues a 15-year note paying 5% for the first 3 years, 5.50% for the next three years, 6 for the next three years, 7% for the following three years, and 10% in the final three years. The note is callable every year.
This is a note which provides the holder with a variable interest rate determined by an index. Usually based on LIBOR or CPI (see definitions).
Example: A financial institution offers a 10-year note whereby it will pay the holder the effective 3-month LIBOR rate plus 1.50% but it will never pay less than 3% or more than 8%.
This is a note which provides the holder with a certain fixed rate provided that an index remain above or below a certain level. If the index breeches the level, interest is lost (either for an entire payment period or for the days during which the index is breached).
Example: A financial institution offers a 12-year note whereby it will pay 7.5% so long as the S&P is over 800. It is falls below 800 on a quarterly measurement day, it will pay nothing for the previous quarter.
Structured notes become more complicated when two or more indexes. This occurs in the case of hybrid range single knock-out notes, or hybrid fixed rate double knock-out notes.
This is a structured note involving two indices, one which sets the rate and the other which must stay in a given range for the note to pay interest. As with the fixed-rate knock-out note, above, if the index breeches the level, interest is lost (either for an entire payment period or for the days during which the index is breached).
Example: A financial institution offers a 15-year note whereby it will pay the effective 3-month LIBOR rate plus 2.50% but it will never pay less than 2.50% or more than 10% unless the S&P falls below 800 on a quarterly measurement day, in which case it will pay nothing for the previous quarter.
This is a structured note involving a fixed rate or return and two indices, both of which must stay in a given range for the note to pay interest. If either index breeches their prescribed levels, interest is lost (either for an entire payment period or for the days during which the index is breached).
Example: A financial institution offers a 15-year note whereby the note will may 8% interest per annum provided the S&P 500 does not fall below 875 and 3-month LIBOR is between 0 and 7%. For each day during which one of those ranges is breached, the note doesn’t pay any interest.
There are many risks in investing in structured notes. They include:
1. The underlying credit risk of the issuer. Even though financial institutions are no longer facing the systemic risks that were faced in 2008, Lehman taught us that any financial institution could fail on any given day.
2. Illiquidity risk - These notes are ordinarily not liquid and, if you need to raise capital, you will have a very difficult time finding a buyer and could be forced to sell them at a price dramatically below par value.
3. Interest rate risk - Most structured notes, like long positions in any bonds, bear the risk that interest rates rise dramatically and the interest produced at the maximum rate in the prospectus does not maintain the real value of the principal.
4. Call risk - The opposite of illiquidity risk is the risk that the note may be called away by the bank. Those notes bearing a call provision should offer the bearer greater up front interest than a similar note without a call provision.
5. Knock-out risk. Knock-out notes, in particular, may bear a profound form of interest rate risk as the notes will not produce any interest should the measuring indicator cross a certain threshold rate (see, for example, the Hybrid Fixed Rate Double Knock-Out Note example above, which does not pay any interest if 3 month LIBOR rises above 7%).
6. Observation risk. Knock-out notes could be structured so that interest for an entire period is lost if an index or indicator is outside of a certain area on an observation date or at any point over a given period. Those notes that are structured so that interest is not lost for the entire period, but only for days where an index or indicator is outside the required range.
With any structured note, it is important to carefully read the prospectus provided by your broker to determine which risks apply and measure whether the compensation is appropriate for the risk.