What Are Structured Notes, and How Do They Work?

You may be hearing a lot about structured notes and wondering how they work and whether they suit your portfolio. Also called structured investments, they’re becoming popular with retail investors building retirement savings accounts.

While there are plenty of investment products, from stocks to bonds to cryptocurrencies, investors are seeking more opportunities. Some are looking to diversify their portfolios, and others simply want new ways to try their luck.

While regulatory concerns have some investors avoiding cryptos, many still won’t go all in on stocks because they’re concerned about market volatility. Others may like the investment security that bonds offer, but the yields are low. Wanting a hybrid of stocks and bonds, some investors are turning to structured notes.

Issued by investment banks through brokerages, these notes are a type of derivative that combines elements of stocks and bonds in a single investment product. Returns on structured notes are based on the performance of underlying assets, which could be a single stock or bond or a group of them.

For example, banks have issued structured notes tied to the stocks of tech giants such as Alphabet, Amazon, and Apple. Others have issued notes that track the performance of a basket of Cathie Wood’s ARK funds.

Structured notes usually mature in two to five years. Their appeal is that they offer investors the upside of the underlying securities as well as some protection from market downside.

Say a bank offers a three-year note tied to Tesla stock. The arrangement may be that investors earn an annual yield of 10 percent on their invested amount as long as the stock doesn’t drop more than 30 percent from the date of issue. It means that if Tesla dropped 20 percent over that period, you’ll get back your principal amount and the accrued interests. But if you bought Tesla stock directly, you’d lose 20 percent of your investment.

Although you get some downside protection with structured notes, your upside benefits are limited. Additionally, if the stock drops below the required level, you may loss part of your principal.

To diversify their portfolios, some investors are taking up structured notes, which usually offer higher yields than traditional bonds. Access to leverage can also boost returns. But you need to approach structured notes cautiously.

One risk is that the promised yields won’t be achieved if the underlying security performs poorly. Also, these notes are like unsecured debt, and investing in them means putting faith in the bank that issues them. Even if the underlying asset performs well, you may still lose the interest and principal if the issuing bank collapses.

Finally, there's no secondary market for structured notes. As a result, they are illiquid, posing a challenge for investors wanting to exit before maturity. Whereas you may be able to sell your notes back to the bank for an early exit, it could be at a steep discount.