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What is a Structured Note?

John Lister
John Lister

A structured note is a financial instrument combining a straightforward loan with a more complicated condition, usually linked to another financial variable. Because the conditions can vary, the risk and value of structured notes can vary immensely. A structured note will often be issued to give the issuer more protection against market changes. They will normally be bought by more sophisticated investors who can better analyze the risks involved.

Large companies often issue financial instruments such as bonds. These are bought by investors who, at a fixed date, get their money back from the company plus interest. This allows the company to borrow money without having to go to a bank. Usually the bonds can be bought and sold during their lifetime, with the current holder receiving the payment when it comes due. The price a bond sells for in such deals will often reflect how confident the buyer and seller are that the company will still be in business on the due date.

Man climbing a rope
Man climbing a rope

A structured note takes the basic principle of the bond but adds a variable factor. This is usually based on a separate financial market or product. For example, a bond might pay five percent interest as well as returning the purchase price. A structured note could pay two percent, plus an extra payment which depends on how well a particular stock market has performed since the note was issued.

Often the issuing company will pick these variables to help its financial position or reduce risk. For example, a gold mining company might tie the interest paid on a note to the price of gold. Because the price of gold affects its revenues, the interest should be more affordable whichever way the price goes. If the price of gold falls the company will have less revenue, but won’t have to pay out so much in interest on the notes.

The condition attached to a structure note can be more complicated. It may only apply to movements in one direction. For example, a firm could promise to pay variable interest matching any rise in the stock market, but stick to a fixed rate if the stock market falls.

The condition could even follow an inverse pattern, for example with the company paying the note buyer a lower rate of interest as the Federal Reserve’s bank rates rise. This might seem counterintuitive but does make some sense in some situations. For example, if the company finds it more expensive to borrow from banks during the note’s lifetime, it’s likely to have less profit to spend on repaying the note when it comes due.

Because the conditions attached to a structured note are different in every case, there are no hard and fast rules about whether they are a good or bad investment. Buyers need to put a lot more work into analyzing whether or not they are likely to make a good profit. This is particularly true when buying from a holder during the note’s lifespan rather than buying it directly from the company when it is issued.

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