How Structured Notes Might Fit into Your Retirement Portfolio – Pt. 1

In the never-ending quest for better returns and more income, investors and advisers alike are turning to a lesser known vehicle called structured notes (SN). Though not well known by the average investor, the SN has been a staple in the fee-based adviser world since the mid 1990s, with an estimated market value of over $2 trillion according to the website www.structuredretailproducts.com.

SNs are not one asset class. They are considered a “hybrid security” because they have the characteristics of both stocks and bonds. SNs are generally issued by large banks like Goldman Sachs, J.P. Morgan, Barclays and others. The terms vary in time to maturity i.e., one year, 18 months, two years, etc.; as well as the market exposure i.e., DJIA, S& P 500, Russell 2000 or even an individual issue stock, or ETF.

The purpose of the SN in a retirement portfolio scenario is to meet the client’s objectives of income, growth and/or principal protection. What differentiates SNs relative to other financial assets is they are one of the few investment vehicles that can be used to provide a defined outcome.

In their most basic design, SNs are investments that combine a “low risk/low return” component of bonds (like a zero-coupon bond) with a “higher risk/higher return” derivative (like a call or put option) on a selected asset, often an equity index or individual issue, as mentioned earlier. The SN is not about owning a specific index or security but rather about customizing an investor’s exposure to that underlying asset. The advantages of this approach are 

1. reducing volatility of owning an index or individual issue, 
2. providing the potential of higher yield or coupon return while eliminating interest rate risk, 
3. can participate in any type of market – up, down, sideways, 
4. helps an investor fine tune their portfolio with their risk profile and 
5. helps an investor broaden their diversification in asset class, investment theme, markets and sectors.

There are three basic types of structured notes:

1. Principal Protected Notes – guarantees some or all of the investors capital back at maturity plus any participation in the performance of the underlying asset(s).
2. Income Notes – provides the opportunity to receive above average periodic income payments
3. Growth Notes – provides the potential of the performance of an underlying equity index (or other asset) while also allowing for some downside protection against some of the underlying assets’ losses.

As with any and all types of investments, there are risks involved with SNs that need to be evaluated and understood before making them part of any portfolio. Every part of your portfolio must be well thought out and be in line with your objectives and goals, and SNs are no exception. Things to very mindful of when considering SNs are (but not limited to 1) the credit risk of the financial institution issuing the note, 2) market risk, 3) liquidity risk, 4) maturity risk,5) call or prepayment risk, 6) exchange risk (for notes involving foreign currencies), 7) tax risk and 8) certain note features like auto-calls, caps, participation rates, leverage values, etc.

Typically, SNs are investment vehicles recommended and sold by advisers and brokers. As a general rule, SNs are designed with no additional compensation built into the pricing and that is why you will find mostly fee-only advisers and advisory firms offering them. There are brokers and brokerage firms that do add on commissions or loads to the SNs. This can cause a reduction in the investors overall rate of return. It is important that you ask and understand the compensation structure. We are not saying one is good or bad, we are saying – it’s your money and you need to know what you are being charged and is that charge adding value to your portfolio.

Obviously, I am giving you an abridged version of the structured note world. Like any other asset, these are just another tool for you to use in the building of your retirement portfolio. What we have found to be the most successful use of SNs is when they are laddered in time and maturity and used methodically as an enhancement to a portfolio versus a core component of a portfolio.

As with anything else, please please please – seek counsel before investing in structured notes. Talk to your advisers, accountants, lawyers and understand the advantages, consequences and impact structured notes can have on your portfolio.

Read Part Two Here

Per compliance regulations please note – Structured notes involve risks not associated with an investment in ordinary debt securities. The securities are not bank deposits and are not insured by the Federal Deposit Insurance Corporation or any other governmental agency, nor are they obligations of, or guaranteed by, a bank. The securities will not be listed on any securities exchange and secondary trading may be limited. Therefore, there may be little or no secondary market for the securities. Accordingly, you should be willing to hold your securities to maturity. The securities are subject to the credit risk of the Issuing Bank, and any actual or anticipated changes to its credit ratings or credit spreads may adversely affect the market value of the securities.