We have seen markets go down in the first half of this year. While there are near term concerns, there is also opportunity. Can we manage risk while taking advantage? How?
Traditional portfolio diversification uses different assets classes that have historically have not moved together, or been correlated, to smooth out market movements. Example is bond-type holdings have improved in price while stocks have gone down in past recessions. Inflation and interest rate increases mean this balance may not work as well now.
Structured notes are hybrid securities that offer payouts from multiple components. They are generally debt obligations of the issuer bank with defined outcome from underlying options or hedges inside the note. Investors need to pay attention to both the creditworthiness of the issuer behind the debt instrument, as well as the risk and potential reward of the options.
How are structured notes used in portfolios?
How structured notes may be used in a portfolio will vary with both the particular note and each investor. A common way these instruments are used is a part of the allocation to alternative assets. If this component is tied to a stock market index like the S&P 500 this presents a different risk and correlation profile for the note as opposed to a note tied to a commodity futures contract.
Pros and cons of structured notes
- By coupling the option with a bond, the investor may be in a better position to take a risk with the option knowing that they will receive the payout from the bond component. For example, if the note is issued by a financially stable bond issuer, it’s easier to take a chance with an option that looks toward significant increases in market values.
- Structured notes may offer investors a chance to look for investments offering a wide range of payouts and risk combinations that may not be available elsewhere.
- Investors must perform their due diligence on the note issuer as well as on the underlying option strategy. Back in 2008 Lehman Brother issued a number of structured notes and investors holding them after the fall of Lehman may have seen reduced values related to concerns over the issuer.
- Structured notes often lack the liquidity of a regular bond. Investors considering structured notes should do their homework on this key issue before investing.
- Structured notes have historically been subject to higher levels of default risk than a similar note or option sold separately.
Are structured notes right for your portfolio?
Structured notes can have a place in your portfolio as long as you understand the potential risks as well as the potential rewards. Be sure to work with your financial advisor to perform a proper level of due diligence on any structured note you might be considering.
Buffered notes are similar in many respects to structured notes, except that a buffered note will offer a degree of downside protection. Typically, this is a percentage of the potential loss, often in the 10% – 30% range. In other words, an investor would be shielded from a potential of the total loss possible but not the entire potential loss.
In exchange for this downside protection or buffer, the amount of upside participation from the underlying option component might be limited as well. When looking at a buffered note, some things to consider:
- While your downside risk is partially limited, so is the upside participation in the note’s return.
- Buffered notes are generally designed to be held until maturity and often lack liquidity. An investor considering investing in one of these notes must take this into consideration in light of their own possible liquidity needs.
- As with structured notes, the creditworthiness of the issuer is a crucial consideration.
- Investors should fully understand how their returns will be calculated in terms of the buffer amount, the cap on their upside and the method used to make the return calculation.
Are these notes right for you?
Whether structured notes or buffered notes, it pays to discuss these options with a financial advisor who fully understands them, as well as your own unique investing needs. It’s especially important to work with an advisor who will objectively explain both the potential upsides and downsides of both types of notes.
Timothy Canty, Vice President – Investment in Wedbush Securities San Diego office, observes, “We’ve found notes complementing our core holdings help manage overall risk in the portfolio. We can express our conviction, while getting some downside protection and income in ways that traditional portfolio “balancers” are not delivering today.”
If these types of notes are of interest to you, we suggest you contact your Wedbush financial advisor.
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These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.