Structured notes are unrated debt instruments issued by large banks which make periodic payments that depend on the performance of an underlying asset or group of assets, such as a single stock, stock indices, a basket of stocks, interest rates, commodities or foreign currencies.

For example, you can have a structured note that is linked to the performance of Apple’s stock, the S&P 500 index, a basket of stocks with Google, Amazon and Netflix, or the WTI crude index.

Basically, the choices for the underlying asset(s) are limitless and structured notes allow investors to benefit from the upside potential of the underlying or reference asset(s) while also limiting exposure to the downside.

The notes can be structured to be either principal-protected (PPN’s) or capital-at-risk notes. Under principal-protected notes only coupon payments are typically at risk, while both coupon and principal payments are contingent on the performance of the underlying asset(s) for capital-at-risk notes.

Additionally, since issuers of PPN’s are obligated to repay principal, these notes typically have significantly lower contingent coupons than their non-principal-protected or capital-at-risk counterparts.

Unlike traditional investment products (such as bonds), investing in structured notes involves exposure to considerable risks.

A bond issuer, for instance, is obligated to make periodic coupon payments and repay the principal in full, unless there is a default.

For structured notes, the performance of the underlying assets is assessed periodically (usually quarterly or semi-annually) to determine if a coupon payment is to be made. Similarly, at maturity, the extent to which the principal is repaid relies on the performance of the underlying assets (except for PPN’s where principal repayment is guaranteed by the issuer).

Nevertheless, an investor can add features to improve the probability of payouts under a note, but this will come at the expense of an otherwise higher return. Some of the risks associated with structured notes are:

CREDIT RISK

Structured notes are unsecured debt obligations of issuers. Consequently, the prospects for principal repayments are dependent upon the credit worthiness of the issuing bank. In order to mitigate credit risk, therefore, an investor should only consider notes being issued by high creditworthy banks with solid balance sheets.

LIQUIDITY RISK

Due to their highly customised nature, investors should be willing to hold these securities to maturity as there may be little or no secondary market for the securities. Furthermore, if investors want to sell their investments before maturity they may have to do so at substantial discounts from the issue prices, and as a result they may suffer substantial losses.

RISKS WITH RESPECT TO CALL FEATURES

Similar to a bond, a structure note may be “called” or redeemed before its contracted maturity date. Call features under a structure note usually come in the form of an “issuer call” which allows the issuer to redeem the note (usually in full) on any contingent coupon date, and/or an “auto-call” provision where the issuer is obliged to repay the note in full on certain conditions of performance of the underlying instrument. If the security is called early, an investor will not receive any payments after the call date and consequently his or her anticipated payouts under the note may be significantly reduced. Additionally, there is no guarantee that an investor will be able to reinvest the call proceeds at a comparable rate of return for a similar level of risk.

VALUATION RISK

There is no uniform standard for pricing structured notes and these securities are essentially priced using a best-guess approach, which makes ongoing valuation exercises difficult to achieve. However, so long as investors are prepared to hold their investment until maturity, regular valuations may not be necessary.

The principal investment may be guaranteed but the returns are not, as returns are based on the performance of the underlying instrument(s) for structured notes. An investor can however include a “memory” feature which allows for any missed contingent coupon payment(s) to be made at the next eligible coupon payment date.

Let’s take a look at a structured note to see how the security works. JP Morgan recently issued a two-year auto-callable note linked to the performance of the stock price of Hess Corporation. The note offered a contingent coupon rate of 11.9 per cent per annum payable quarterly, included a memory coupon feature, and had a 50 per cent downside protection on the stock price for the payments of both coupons and principal. At the end of each quarter the stock price of Hess is observed to determine the extent to which any payouts are to be made. If, on the first observation date, Hess’s stock price is at or above the strike price (price of the stock when the note was issued), the note will be called “automatically” and the investor will receive his principal investment along with the coupon payment for that quarter. If the stock price has fallen — but not by more than 50% of the strike price (also called the protection barrier) — the investor will receive a quarterly coupon payment and the note will be extended until at least the next coupon payment date.

However, should the stock price be lower than the protection barrier, no coupon will be paid for that quarter. But, owing to the memory feature, that missed coupon will be eligible for payment at the next coupon payment date provided that the stock price is above the protection barrier. If the note has not been called, at maturity the principal amount will be repaid in full along with the last coupon amount once the stock price is above the protection barrier. However, if the stock price is below the protection barrier at maturity, the investor will lose a portion of his principal equal to the extent to which the price of the stock has fallen in comparison to the strike price. For instance, if the price has fallen by 60 per cent, then the investor will lose 60 per cent of his principal and will also not receive any coupon on the maturity date.

Structured notes therefore allow investors to benefit from the upside potential of the underlying asset(s) while also limiting exposure to downside performance.

Investing in structured notes, however, exposes the investor to significant risks of loss and, as a result, is not suitable for everyone. Structured notes are more suitable for high net worth individuals and institutional clients due their complexities, deal sizes and inherent risks.

As always, be sure to consult with your financial practitioner to determine if structured notes are right for you.

Eugene Stanley is the VP, fixed income & foreign exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm