Structured notes

A structured note is a form of financing where a business issues a security that has been modified with a derivative component. The purpose of this hybrid security is to alter the risk/return profile of the instrument, usually to meet the specific needs of an investor. As an example of a structured note, an issuer sells a bond to an investor at face value that generates a 7% annual return to the investor. However, since the investor is risk averse, there is also a component of the bond that allows the investor to put the bond back to the issuer if market interest rates increase above 7%. This form of structuring allows the investor to benefit from any upside potential in the bond, while shifting all downside risk to the issuer.

As another example, a bond is issued that has no stated interest rate. Instead, it pays out whatever interest rate matches changes in a major stock index. Thus, if the Dow Jones increases by 2%, the interest rate paid will be based on that amount.

As a third example, the bond component of a security could pay 6% interest, while a derivative component could provide an additional payment boost to investors if the price of silver exceeds a certain amount over the investment period.

A structured note is most commonly used in situations where an investment is clearly outside of the comfort zone of an investor, so the issuer must make modifications to make the investment more palatable to the investor. Structured notes are also packaged and sold to larger groups of investors by investment banks.

The type of investor who normally invests in structured notes wants to protect the principal portion of the investment, while retaining the ability to profit from upside potential.

Investors should be careful to read the fine print associated with structured notes. In some cases, only a portion of the downside is protected, or the principal will be at risk if the issuer defaults. Consequently, only sophisticated investors should purchase these products. Also, these products can be relatively expensive, given the cost of the derivative portions of the instruments.