Morningstar - Q3 2020 - 39

With Structured Notes, It's Buyer Beware
These securities may look appealing
on paper, but investors should understand
their drawbacks.

STRUCTURED NOTES

Amy C. Arnott and Maciej Kowara
Structured notes, which are basically a stock/bond
hybrid with a limited life span or maturity, sound
appealing on paper because they often combine
high coupon rates with some level of principal
protection. But their embedded costs, complexity,
lack of liquidity and transparency, and often
unfavorable payoff profiles make them difficult to
use in a portfolio. In most cases, investors should
only use these products with caution or avoid
them altogether.
Structured notes have been subject to widespread
academic criticism and took a serious reputational
hit during the global financial crisis in 2008-09,
when investors holding structured notes issued by
Lehman Brothers lost nearly all their principal.
Since then, though, the products have regained
some ground.
Structured notes now represent a small but
growing type of investment globally, with about
$2 trillion in global issuance outstanding as of
2019, based on data from Structured Retail
Products, a news and data provider that covers
the industry. About 53% of this total was in the
Asia-Pacific region, with the remainder split
between Europe and the Americas. Because not all
structured notes are registered with regulators,
some experts estimate the total market size at
more than $3 trillion globally.
Structured notes have been increasingly popular
partly because they've been one of the few places
to find yield as interest rates continue their

long-term decline. Recent structured notes have
offered coupon rates of 7% or more. They've
also been touted as a way to protect principal for
risk-averse investors. In Europe and Asia, these
products are often used as a steppingstone into
equities for investors who rely heavily on
fixed-income securities and bank savings accounts.
With the huge spike in market volatility and
sudden collapse of the 11-year bull market in 2020,
structured notes have been gaining more
appeal. Monthly issuance of structured notes
started climbing in late February, based on
data from industry publication Structured Products
Weekly. Year-to-date issuance through early
April totaled about $20.7 billion in the United
States, close to double the amount for the same
period in 2019 (Prospect News, 2020).
How Structured Notes Work: The Basics
Structured notes are primarily issued by large
investment banks, such as HSBC Holdings HSBC,
JPMorgan Chase JPM, Barclays BCS, and
Goldman Sachs GS. The notes are set up as senior
unsecured debt obligations of the bank and,
therefore, rank lower in the capital structure
than secured debt. If the issuing bank declares
bankruptcy (as Lehman Brothers did in 2008),
noteholders may or may not receive their principal
back. To structure the notes, the issuing banks
will typically combine a zero-coupon bond
with put or call options. Issuing banks engage in
various hedging strategies, which will often
include options, to offset their own risk during
the life of the note.

Structured notes can either be issued privately
or as registered products. For registered

products issued in the U.S., the issuing bank is
required to file a prospectus with the SEC
that includes extensive details about the note's
coupon rate, maturity date, call features,
payoff profile and appreciation potential, any
downside risk protection (often labeled buffers
or barriers), potential risk factors, and more.
Investors purchasing structured notes in Europe
and Asia have access to similar disclosure
documents.
Although they're increasingly being used
by fee-based advisors, structured products are
mainly sold through brokers, with the selling
broker receiving a commission from the issuing
bank. Investors can typically buy structured
notes in increments of $1,000 and receive
this principal back at maturity (sometimes with
performance adjustments based on an
underlying security) or when the note is called.
To get a better sense of the product landscape,
we dug into the SEC filings for a sample group of
about 50 of the larger structured notes issued
in January. The table below summarizes some of
their key attributes.
Key Attributes for Sample Group

Average Coupon Rate (%)

7.4

Average Term to Maturity

3.8 Years

Average Issuer-Reported Fair Value
(% of Par)

97.1

% of Issues With Upside Potential

34.0

% of Issues Callable Before Maturity

72.0

% of Issues Linked to Underlying
Equity Security or Index

92.0

% of Issues With a Buffer, Barrier,
or Downside Threshold

86.0

Sources: SEC filings and author calculations. Sample group includes
approximately 50 structured notes issued in the U.S. in early 2020.

About three fourths of the issues in our sample
group included features allowing the issuer
to call, or terminate, the note before maturity.
Nearly all the issues also had some sort
of buffer, barrier, or downside threshold, which
is designed to limit losses in down markets;
conversely, caps on potential gains are
also common.

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