How Does a Structured Note Work?

Structured notes are bonds with a derivative embedded in the interest rate calculation to potentially increase the chance of profits. These notes are typically purchased by more sophisticated investors than standard bonds because they are more complicated. The interest rate is not straightforward but relies on the performing of the underlying factor. This factor can be a measure of an index performance, such as the S&P 500 index, or even an underlying options contract.

Structured Note Example

One example of a fairly simple structured note is a bond with a floating interest rate set based on the S&P 500. The bond's rate is set to rise and fall with the S&P, which is thought of as a good measure of the market as a whole. Therefore, if the market is strong, and the S&P index rises several points, the interest rate on the bond will rise proportionally. If the market crashes, the interest rate on the bond will also crash.

In a more complicated scenario, which may be more typical, there is a 10-year bond with several options contracts to increase profit along the way by purchasing more bonds at a given price. If the option is exercised at the right time, the investor could potentially increase profits far beyond the initial interest rate on the debt note.

Advantages of a Structured Note

The main reason investors purchase bonds is for stability. Bonds are very low-risk securities, and this makes them a great way to begin investing or to diversify a portfolio. Unfortunately, this also makes them less profitable than riskier investments. Some investors would prefer to engage in a slightly riskier and more complicated trading option while still retaining some of the benefits of purchasing a bond, such as a low risk of losing principal. Structured notes offer this hybrid investment form. They are still bonds and still have a low risk of default, but they also provide a window to greater profits. 

Disadvantages of a Structured Note

Unfortunately, any time an investor exposes himself or herself to more risk on the market, there is always the potential that the risk will not pay off. For example, if a structured note offers an option to buy at a given price, an investor may decide to exercise the option only to see the price fall the next week. This would leave the investor with overpriced bonds that he or she could not sell for a profit. This risk is inherent in options and derivatives trading. 

When to Buy a Structured Note

If you feel you are ready for a more sophisticated investment model than a straightforward debt instrument, you may consider a structured note. This is a great introduction to derivatives, which are often intimidating to investors, without all of the complications inherent in derivatives trading. It is important to realize that, although structured notes offer more chance of greater profits than bonds alone, structured notes are not a quick answer to high profits. They are best used by investors looking for hybrid options with moderate risk in return for moderate reward.