In this episode of “Investment Management Foundations,” Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement, discusses structured notes, which combine zero-coupon bonds with options (puts and calls) linked to an underlying index like the S&P 500.

VIDEO TRANSCRIPT BELOW

Hello everyone, and welcome to this episode of “Investment Management Foundations.” My name is Gary Quinzel. I'm the Vice President of Portfolio Consulting here at Wealth Enhancement Group. Today's topic, in my opinion, is very interesting. It's about structured notes. What exactly are they and how can you use them in your investment portfolio?

Let's go ahead and take a look at an example of a structure note, and I'll walk you through some of the components and how to understand it. If you take a look at this chart, one of the interesting things about structured notes is that they can pay out an asymmetric return based upon the underlying index that it's attached to. But what is the structure note? A structured note is essentially a combination of a zero-coupon bond, such as a Treasury, that also includes put and call options that are related to either some individual stocks or an underlying index, such as the S&P 500. By investing in this structure, you can get exposure to that underlying index, but in a structure such as this, you can have a buffer against unexpected losses or perhaps amplified return up to a certain cap.

You may be wondering how exactly that might work. So, as I mentioned, the underlying bond will help return capital at the maturity of the bond, and they'll set the tenure of the note. The puts and calls help determine what the underlying structure is. So, in this example, you can see that there's a buffer from 0 to -15%, which is essentially a put spread. So, both buying and selling a put that provides protection against the first -15% returns relative to the S&P 500 on the other side to the upside. By using call options, one can amplify the return you would get relative to the underlying index. However, that put protection in the buffer zone does come at a cost, and to pay for that protection, one must sell calls—in other words, sell upside protection, which limits the max return that this note can get.

So, how would this work in real life? If we pull up the other chart we have here, we can see some numeric examples which help spell out what the potential return for a structure note would be relative to the underlying index. As mentioned, we see that there's amplified returns up to the cap. So, if the underlying index over the tenure of the bond were to go up 10%, we can see that the investor in the note would have gotten 15%. However, if the underlying index went up 25%, we can see that the investor in the structured note would actually be capped out at a max return of 20. If we look to the downside, this is where the real benefits come in. The structured note actually has a protection so that if the underlying index is down 10%, the investor would be flat on return. In other words, they would have relative outperformance of 10% relative to the index. They could then turn around and roll those proceeds into a new structured note or other investment in that underlying asset and have relative outperformance. Once the performance of the index went below the buffer, let's say went down 30%, the investor would then participate on a one-to-one basis below the buffer, and they would be down 15%, which, once again, is relative outperformance. Keep in mind, this is just one example of a structured note, and terms of every structured note can vary considerably.

Structured notes can be created to serve a variety of purposes. For example, they can be created at the dual direction, or absolute return notes, so that an investor can get positive returns in either direction of what the underlying asset did. There's also things like digital return notes and yield-enhancing notes that are structured to pay out coupons based upon performance of underlying assets.

Regardless, structured notes are a little more complex, and so you should certainly speak to your financial advisor to learn more about them if you find this interesting. But structured notes can be a compelling part of a portfolio, because they help create defined outcomes for investors, and they can create hedged equity returns that allow investors to participate in equity markets but also have a little bit of protection to reduce overall portfolio volatility. We hope you found today's episode of Investment Management Foundations helpful, and we hope you join us for future episodes. Thank you so much. Take care.

This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.

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