The first thing to watch out for is the two different options for barrier protection (American & European). An American barrier is observed on any given day during the note’s term, whereas a European barrier is only observed at maturity.
For example, let’s say markets crashed and as a result underlying investments fell below barrier levels within the term of the note – under this the scenario an American barrier note would then track the performance of the underlying holdings to maturity and lose the capital protection feature.
Had the investor been in a European barrier note it would have continued and therefore time is availed for the underlying holdings to come back within barrier levels as stock prices are only observed at note maturity – the European option is deemed safer and therefore preferred over the American.
Another factor worth mentioning is that a structured note is comprised of a bond and derivative component – where the latter takes precedence on the secondary market price of the note.
Therefore investors should be wary of structured note pricing, which uses sophisticated derivative pricing models that take into consideration a number of financial metrics to issue a daily price – in many instances a note price may not be reflective of how the underlying holdings have been performing.
Time to maturity, for example, is a major factor as note value trends to par over duration – this means it is normally not advisable to trade out of the bond until the note is getting closer to maturity and for that reason longer-dated notes should be avoided, should one ever want the option to cash out early.
Lastly, it is imperative that each underlying security is purchased at an optimum time to allow for the principal protection barrier to remain intact and that the term of the note is suitable for the nature of the underlying investments.
Putting it simply the less volatile the security the less chance of barriers being breached over the term of the investment and the more chance of the note doing exactly what it says on the tin.
The final verdict
Structured notes have become a hot topic and there are now a multitude of independent distributors in the offshore investment environment that promote them.
Prudent advisers should take note of the above points as most of the notes being offered are fairly generic and considered as “off the shelf” products, where little detail or information is availed on what is actually under-pinning the structure. A great degree of caution is thus warranted and one has to sift the wheat from the chaff, given that notes rarely come with a "buyer beware" sticker.
Having said the above, if extensive research on all aspects of note pricing and stock selection is conducted to ensure these risks are limited over the term of the note, they can serve a very valid purpose in the overall make-up of an investor’s portfolio.
Click here to read part one, where Sajjan discusses why you would use a structure note.
Harpreet Sajjan is head of portfolio management at Platinum Financial Services