Structured Notes manage 
Risk through buffers, barriers 
And performance caps

2022 closed as the worst year for American markets since 2008. 2023 is off to a better start so far (at least as of the time of this writing), but short term uncertainty persists.

Inflation seems to be heading in a good direction, with the latest data showing that the acceleration of wage growth - which partially contributed to the excess of demand for supplies that weren’t on shelves in 2022 – is slowing. With the Fed trying to pull money out of circulation to fight inflation, this data point indicates their policy may be working.

However, the response to this good news has been an expectation that the Fed may slow its rate hikes, not stop them. Furthermore, as wage growth slows and unemployment increases, (which would be a natural consequence of high interest rates limiting corporate financial resources), a recession may be ahead.

JP Morgan Chase Research, Forbes, and 98% of US CEOs (according to a report by the Wall Street Journal) all expect a recession – or at the very least would not be surprised by one – in 2023. The good news is that most of those same CEOs who expect a recession in 2023 also a expect a recovery before mid-2024.

The problem is, what to do until then?

The brass ring for many investors and wealth managers is this: grow account value without risk of loss.

Generally, a good rule of thumb is that the more growth you want out of an account, the more risk you must take. The more risk you want to avoid, the less growth you can expect from the account. For example, compare the safety and liquidity of an FDIC insured savings account (risk level = watching TV in bed) with holding Bitcoin on an offshore crypto exchange (risk level = skydiving without a parachute).

With everything from Ukraine battle fronts to the price of eggs jostling American markets, protecting against loss while generating either growth or income may be more challenging right now than winning the lottery.

To meet financial objectives during times of elevated uncertainty, some investors may start looking outside of the traditional investment world of stocks, bonds, mutual funds, and ETFs. This is where one may find Structured Notes.

What is a Structured Note? Let’s see what our future robot overlords (ChatGPT) have to say about them:

“A structured note is a type of investment product that combines the features of bonds and derivatives. It is a debt security that pays a return based on the performance of an underlying asset or index, such as a stock market index or a commodity price.

“In simple terms, a structured note is a type of bond that is linked to the performance of a specific asset. The issuer (usually a bank) will promise to pay the investor a return that is based on the performance of that asset. Structured notes can be customized to suit the specific investment goals and risk tolerance of the investor.”

Structured Notes may be issued to investors by banks or investment companies. Like bonds, they have a maturity schedule. Also, like bonds, they can be traded prior to maturity with some pricing and liquidity risk.

If the market for the note is appealing at the time the owner wants to sell it, it may sell for a premium, in which case the investor realizes a capital gain (long term if held for more than 1 year, short term if held for 1 year or less). If the note looks less attractive than it did at purchase, it may sell for a discount. In this case the investor would realize a loss.

Broadly speaking, it may be helpful to look at two broad categories of Structured Notes – Growth Notes and Income Notes. In both cases, the notes track an underlying asset, such as an index fund(s) or stock(s).

The purpose of a Growth Note is to generate appreciation of the original investment. Over the maturity schedule of the note, the investment bank will return a certain percentage of the underlying assets to the investor up to a limit, called a Cap.

For example, an investor could track the S&P 500 index over three years, with a performance cap of 40%. If the index grows 20% over that time, the investor gets 20%. If the index does 50%, the investor gets 40%. Growth cannot exceed the Cap.

It’s important to know that these instruments come with fees or may pay the firm who sells them a commission. Always remember to ask about fees, compensation, liquidity, taxes, risks and penalties when exploring off-the-beaten-path investment options.

Back to our S&P 500 Note. The investor may see a maximum gross return over 3 years of 40% in this hypothetical example. But what happens if the index is negative?

The investor can decide on a certain amount of risk to protect against using a Buffer. The bigger the Buffer, the lower the Cap.

Buffers can be anything the investor wants, all the way up to 100%. However, to maintain the desired exposure to growth, a less-than-100% buffer may be necessary.

What would a hypothetical buffer of, for example, 40% buffer over three years do?

A 40% buffer on the S&P 500 means that the index would have to fall more than 40% over three years for the account to return a loss. It may be of interest to know that in the history of the S&P 500, this has never happened. Of course, having written this, it will probably happen tomorrow. I hope someone out there is knocking on wood.

At the end of the maturity schedule, if the Structured Note returns a gain, the investor realizes a Long Term Capital Gain equal to the amount of that gain. If the note returns a loss, the investor reports a Long Term Capital Loss on her taxes.

But what about Income Notes, how do those work?

Income Notes behave more like bonds than Growth Notes. First, like bonds, the purpose of these notes is income and principal protection, not capital appreciation.

In the same way a bond returns its par value at maturity, a Structured Income Note may return the investor’s principal at maturity. $100,000 invested in an income note could return $100,000 at maturity.

Before it matures, the note may generate income similar to a coupon (interest) payment from a bond. The note has a stated yield as desired by the investor. A 10% income note on a $100,000 investment may generate $10,000 of annual income before fees.

This income may be well above what one can expect out of investment grade Treasuries or Corporate Bonds. If an investor wants annual yield of 10% before fees, they can buy a note that may deliver that yield.

It is important to know that the yield returned by the Income Note is fully taxable, similar to interest payments from a corporate bond.

Is the Note buffered against loss the way a Growth Note is? No.

You’ll notice how all of the above statements are qualified by “may” and “can.” That’s because the income from the Note has the potential to shut off under certain conditions, and the investor may lose principal under certain conditions.

Income Notes use Barriers, not Buffers. You can think of a barrier like a roadblock. It’s hard to get over it, but once you do, you are completely on the other side of the roadblock.

Assume an Income Note has a Barrier of 40%. If the underlying asset or assets fall in price by more than 40%, then the income stops. If the underlying asset climbs above that barrier, income starts up again.

If, after the maturity term ends, the underlying assets are below the Barrier level, in this case let’s say the S&P 500 was down 45%, then the investor is completely on the hook for the 45% loss. In this case a $100,000 investment would return $55,000 after three years. Ouch.

The investor can increase the Barrier, but that will come at the expense of reduced yield. This is similar to the Growth Note, where larger Buffers mean lower Caps.

What may be appealing to investors about Structured Notes is the ability to customize them. Investors may set targets for growth or income balanced against what Buffer or Barrier they want. The Notes may have short maturity schedules compared to Treasury Notes (2 – 10 years) and Bonds (up to 30+ years) and may be traded after purchase the way a bond is.

The notes are written by financial institutions like investment companies or banks, which entails business risk. As we saw in 2008, huge firms can make huge mistakes and go under.

If the bank holding your Structured Note crashes, you may see a total loss of your investment. For this reason, it’s advisable to only look at notes from financially strong, large, old banks. Think Barclays, JP Morgan Chase, Goldman Sachs, and so forth.

An investor may also reduce the business risk of the Structured Note by holding other investments. Diversifying investments into a broad range of assets is a tried and true way to reduce risk. A Structured Note should be thought of as a piece of a puzzle, not the whole puzzle.

If you want to learn more about Structured Notes and whether they may be a good fit for your portfolio, send us a message or give us a call. You can also schedule a meeting right from our website. We look forward to hearing from you.