Structured Notes

A Structured Note is a debt obligation that also contains an embedded derivative component with characteristics that adjust the security's risk/return profile. The return performance of a structured note will track that of the underlying debt obligation and the derivative embedded within. It is a hybrid security that attempts to change its profile by including additional modifying structures. A simple example would be a five-year bond tied together with an option contract. This structure would work to increase the bond's returns.

Sometimes called "hybrid debt," it is an intermediate term debt security, whose interest payments are determined by some type of formula tied to the movement of an interest rate, stock, stock index, commodity, or currency. Although structured notes are derivatives, they often do not include an option, forward or futures contract.

Structured notes provide investors with an opportunity to take advantage of views not only about the direction of interest rates but the volatility, the range, the shape of the term structure (i. e., long term rates vs. short term rates), and the direction of commodity and equity prices.

There are a wide variety of structured notes, including inverse floaters and range notes.

An inverse floater is a floating rate instrument whose interest rate moves inversely with market interest rates. Many structured notes, and particularly inverse floaters, have a leverage factor in which the rate adjusts by a multiple, such as 1.5 times LIBOR.

Range notes typically pay interest at an above-market rate if LIBOR stays within a specific range, which may change according to a schedule. If LIBOR moves outside of that range, these notes may revert to a lower interest rate or no interest at all.

Other types of structured notes pay a promised rate but allow additional payments based on the movement of a commodity price or stock index.

Structured notes are financial products that appear to be fixed income instruments, but contain embedded options and do not necessarily reflect the risk of the issuing credit. These options may be 'plain vanilla' or they may be highly leveraged exotic options. Due to the fact that each one is unique, the risks inherent in any one structured note may not be obvious.

Structured notes may be used prudently to mitigate the risks to a portfolio of a systemic shock. A structured note could be purchased with an embedded currency put to hedge currency risk. The premium would be considered insurance, as opposed to speculation.

Structured notes may also be used by investors to expose their portfolios to asset classes or markets to get involved with asset classes and markets outside of their general scope of business.

Many of these notes can cause the investor to lose part or their entire principal. Many investors are not aware of the inherent risks when buying a structured product. Of course, there must be trade-offs, since adding a benefit one place must decrease the benefit somewhere else. As you no doubt know, there is no such thing as a free lunch.

Still Interested?

Take a look at a common structure; the buffered return-enhanced note (BREN). Buffered means it offers some but not complete downside protection. Return-enhanced means it leverages market returns on the upside. The BREN is pitched as being ideal for investors forecasting a weak positive market performance but also worried about the market falling. It sounds perfect, almost too good to be true, which of course, it is.

Pulling Back the Curtain

A good example is a BREN linked to the MSCI Emerging Market Price Index. This particular security is an 18-month note offering 200% leverage on the upside, a 10% buffer on the downside and caps the performance at 24%. For example, on the upside, if the price index over the 18 month period was 10%, the note would return 20%. The 24% cap means the most you can make on the note is 24%, regardless of how high the index goes. On the downside, if the price index was down -10%, the note would be flat, returning 100% of the principal. If the price index was down 50%, the note would be down 40%. I'll admit that sounds pretty darn good until you factor in the cap and the exclusion of dividends.

The key here is to analyze how this security would have performed versus its benchmark Index (MSCI Emerging Market Price Index). It may have been better to purchase the index out right over certain selected time frames.

Principal Protected Structured Notes

Engineering a PPN, Ensuring the Guarantee

When a financial engineer wants to guarantee the nominal value of the original invested principal, a hedge will be involved. There are two common structures, which describe how the synthetic investment is created, and that are used to create a PPN. The main difference between the two is the hedging technique. In the zero-coupon bond structure, the simplest of which is a static hedge, the purchase of protection occurs when the PPN is created. The other structure, the constant proportion portfolio insurance (CPPI) structure, is more complex and uses a dynamic hedge to implement protection. With dynamic hedging, protection may be put in place and removed throughout the term of the PPN.

Zero-Coupon Structure

The zero-coupon structure, termed plain-vanilla by the financial engineering crowd, consists of a zero-coupon bond and a call option package on the underlying.

When the PPN is issued, about 70% of the principal is used to purchase a zero-coupon bond with a maturity matching that of the PPN, which matures to the value of the original principal. It is this purchase of a zero-coupon bond that protects, or hedges, the principal and, because it remains in place throughout the term of the PPN, it is a static hedge. The remaining funds (minus fees) are then used to make a leveraged investment in the underlying that have a notional value equal to the invested principal.

Because of these limitations and a requirement for the existence of suitable call options, the zero coupon structure is not as widely used as the constant proportion portfolio insurance structure (CPPI).

Constant Proportion Portfolio Insurance Structure The CPPI structure is more flexible and more widely used. When a PPN is created this way, the initial step is an investment in the underlying equal to the principal invested less fees. The need for principal protection is determined by the performance of the underlying and, if principal protection is needed, a zero-coupon bond is purchased. Protection will be subsequently sold if it is no longer needed. Hedging, in this case, is dynamic because it is based on market events; therefore, the performance of the underlying must be constantly monitored and with the use of a complex formula, financial engineers determine whether protection is required.

If, during the term of the investment, the net asset value of the PPN equals the cost of protection, full protection must be purchased. This is the "knock-out scenario". If this occurs, the return of the original investment is the only possible outcome. If the knock-out scenario occurs early in the term of the PPN, an investor is left holding the bag, so to speak, with his or her funds locked in and purchasing power declining at the rate of inflation.

We have recently seen an interesting Principal Guaranteed structure involving various insurance company guarantees against adverse outcome contingencies and with a range performance bonus based on underlying assets.

This structure comes from the new asset class of Litigation funding. Recent Private Placement offerings have taken the form as presented below:

Litigation Funding 'Principal Protected Notes' have offered Investors a guaranteed return of 9 % p.a. over 2 years

Plus bonuses to equal a 28% return over the 2 years (18% +10% at maturity); 14% p.a.

PLUS a 100% Capital Guarantee via insurance coverage and depository protection

All with an additional Performance Bonus option that can enhance the returns to as much as 25% p.a. based on the performance of litigation cases funded over the 2 year investment period.

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