A structured note is a type of bond issued by a bank or a company.
A traditional bond repays the principal invested at maturity and a fixed or variable interest rate during its life. Whereas, the interest rate or repayment amount for a structured note is determined by reference to the price of an asset. The asset may be an equity, bond, currency, interest rate, commodity or property market.
The term of a structured note may vary from one month to ten years or more. The owner’s capital may be fully protected, partially protected or completely at risk.
Investors use structured notes to protect capital, capture growth, earn an enhanced income or track the price of the asset. Typically, either, the owner’s capital is protected and the return is linked to the upside of a market. Alternatively, the note pays a high interest rate but the owner’s capital is at risk.
The owner of a note is dependent upon the issuer to repay the principal plus any interest due. Hence, the credit rating of the issuer is important and an investor should be comfortable with it before buying a note.
In common with other securities such as government bonds, they are tradable on a daily basis. However, there will probably be only one market maker, the issuer, which may affect liquidity of the note.
The most popular types of structured note are capital protected notes and reverse convertibles.
Capital protected notes are similar to traditional bonds except that the coupon is linked to the performance of an asset. Hence, a note may pay an enhanced coupon for each year that the S&P 500 Index fixes above a certain level, otherwise no interest is paid. Alternatively, it may offer a proportion of the growth in the asset over the life of the note and make a single payment at maturity.
The owner of a reverse convertible is willing to risk capital in return for an enhanced income or the potential for capital growth. If the price of the asset falls below a pre-agreed level, the owner will lose capital on a one-for-one basis. Hence, depending on the terms of the note, if the asset price falls by 20%, the note will repay 80% of the initial investment. The note pays an enhanced income to compensate the investor for putting capital at risk. Reverse convertibles may be settled in cash or by the physical delivery of the related asset.
In general, notes are taxed as income but there are certain types of note where the provider may have been advised that they should be taxed as capital. Investors should seek their own advice in respect of taxation etc.
In addition to the credit risk of the issuer and the market risk that the note does not pay any coupon or all of the initial capital, there are a number of other risks associated with notes (see Risks of Structured Investing).