By John Drachman
For many investors who’ve ridden the market’s ups and downs from the Great Recession to today’s Pandemic Era, the idea of reducing equity risk can get downright appealing.
Those in search of an attractive, risk management complement to a traditional portfolio might consider exploring the advantages – and risks – of investments in something called “structured notes.” Also referred to as principal-protected notes, these vehicles typically combine a zero-coupon bond with an option on an underlying equity index. “At their most basic, these are buy-and-hold investments with principal protection guaranteed by the issuer,” according to Wealth Oak Wealth Advisors.
Through the average structured note, your return tracks equity trends if the market does well. If the market heads south, your initial principal – which was invested in a bond not the equity market – remains protected.
Beyond the typical note, there are many varieties: Some have customized structures that provide a credit if the linked index performs exceptionally well. Others may reduce the protection level for more upside potential. Structured notes can provide:
- Downside marketplace protection
- Upside market participation with or without leverage.
- A specified payment at maturity if certain market conditions are met or sidestepped.
- Certain interest payments at various points in time if certain conditions are encountered or avoided.
Structured notes also offer retail investors a way to access areas of the market that may previously been beyond reach. For example, a bear-minded investor might opt for a note that offers greater exposure to gold futures. This way if the gold futures declined in value — and providing the bond included a principal preservation guarantee – the worst outcome could leave the investment value right where it started.
Who wouldn’t want upside potential with downside protection through a structured note? The SEC’s structured note bulletin answers with this caveat: “While structured notes may enable individual retail investors to participate in investment strategies that are not typically offered to them, these products can be very complex and have significant investment risks. Before investing in structured notes, you should understand how the notes work and carefully consider their risks.”
One of major risks pertains to the credit risk of the issuer. Even major institutions, like Lehman Brothers in 2007, can default on their underlying obligations under certain adverse conditions. To keep the level of risk tolerable, most investors should probably not deploy more than 5% to 15% of a portfolio allocation to structured notes.
The Bottom Line
Used as part of a diversified portfolio, “structured notes can reduce the portfolio’s equity risk and potentially enhance total return,” concludes MarketWatch’s William Droms. While a structured note can open up opportunities, the wrong issuer or institution can slam that door shut. If you’re uncertain about the risks behind a structured note, consider consulting a financial advisor. Finding the right financial advisor to fit your portfolio needs may be easier than you think.
John Drachman is a contributing writer to MyPerfectFinancialAdvisor the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.