Structured Notes: Key Disadvantages and Risks for Investors

Structured notes are debt obligations that combine traditional bonds with derivatives to create customized investments. They offer diversification benefits and limited downside protection, but also carry significant risks, including credit risk, illiquidity, and complex or misleading pricing. Investors may also face call risk and unfavorable tax treatment. The collapse of Lehman Brothers in 2008 serves as a reminder that even products promising safety can expose investors to serious losses when the issuer fails.

What Is a Structured Note?

A structured note is a debt obligation—basically like an IOU from the issuing investment bank—with an embedded derivative component. In other words, it invests in assets via derivative instruments. A five-year bond with an options contract is an example of one kind of structured note.

A structured note can track a basket of equities, a single stock, an equity index, commodities, currencies, interest rates, and more. For example, you can have a structured note deriving its performance from the S&P 500 Index, the S&P Emerging Markets Core Index, or both. The combinations are almost limitless, as long as they fit the concept: to benefit from the asset’s upside potential while also limiting exposure to its downside.

Benefits and Limitations of Structured Notes

Investment banks advertise that structured notes allow you to diversify specific investment products and security types in addition to providing overall asset diversification. However, there can be such a thing as over-diversification, whereby overall returns can be negatively impacted. It is important to understand how a particular structured note achieves diversification. For example, is there a high degree of correlation between assets held in the note?

Investment banks also often advertise that structured notes allow you to access asset classes that are either only available to institutions or hard for the average investor to access. But in today’s investing environment, it’s easy to invest in almost anything via mutual funds, exchange-traded funds (ETFs), exchange-traded notes (ETNs), and more. Besides that, do you think investing in a complex package of derivatives (structured notes) is considered easy to access?

The only benefit that makes sense is that structured notes can have customized payouts and exposures. Some notes advertise an investment return with little or no principal risk. Other notes offer a high return in range-bound markets with or without principal protections. Still, other notes tout alternatives for generating higher yields in a low-return environment. Whatever your fancy, derivatives allow structured notes to align with any particular market or economic forecast.

Additionally, the inherent leverage allows for the derivative’s returns being higher or lower than its underlying asset. Of course, there must be tradeoffs, since adding a benefit in one place must decrease the benefit somewhere else. As you no doubt know, there is no such thing as a free lunch.

Key Risks and Drawbacks of Structured Notes

Credit Risk

If you invest in a structured note, then you have the intention of holding it to maturity. That sounds good in theory, but did you research the creditworthiness of the note’s issuer? As with any IOU, loan, or other types of debt, you bear the risk that the issuing investment bank might get into trouble and forfeit its obligation. 

If that happens, the underlying derivatives can have a positive return, and the notes could still be worthless—which is exactly what happened to investors in 2008 during the collapse of Lehman Brothers structured notes. A structured note adds a layer of credit risk on top of market risk. And never assume that just because the bank is a big name, the risk doesn’t exist.

Lack of Liquidity

Structured notes rarely trade on the secondary market after issuance, which means they are highly illiquid. If you need to get out for any personal reason or because the market is crashing, your only option for an early exit is to sell to the original issuer.

Inaccurate Pricing

Since structured notes don’t trade after issuance, the odds of accurate daily pricing may be low. Prices are usually calculated by a matrix, which is very different from net asset value. Matrix pricing is essentially a best-guess approach. And the original issuer does the guessing.

Additional Risks Associated with Structured Notes

Call risk is another factor that many investors overlook. For some structured notes, it’s possible for the issuer to redeem the note before maturity, regardless of the price. This means it’s possible that an investor will be forced to receive a price that’s well below face value.

The risks don’t end there. You also have to consider the tax factor. Investors may be responsible for paying federal taxes on structured notes, even if the note hasn’t reached maturity and the investor has not received any cash. Also, when sold, the proceeds may be taxed at the ordinary income rate, rather than at the more favorable capital gains rate. Each offering is different, and the U.S. Securities and Exchange Commission (SEC) advises investors to carefully read the prospectus of a structured product to understand the tax implications.

As far as price goes, you will likely overpay for a structured note, which relates to the issuer’s costs for selling, structuring, and hedging.

Understanding Principal-Protected Notes (PPNs): An Example

There are various different forms of structured notes. Let’s take a look at how one of the most coveted types, the principal-protected note (PPN), works.

PPNs are advertised as very safe as they, in theory, come with no downside risk. The return of the initial investment is guaranteed by the issuer, on top of any gains. In reality, PPNs are not risk-free at all.

PPNs are exposed to credit risk, meaning you get zero if the issuer goes bust, and they often carry caps that take a lot of the shine off the assumed benefits.

Let’s look at a hypothetical example of an 18-month structured note with principal protection linked to the returns of the S&P 500. Based on how it’s advertised, investors may think that if the index rallies 50% over the period, they’ll pocket all the gains, and if the index dips in value, they’ll get back what they invested. But that is not usually the case.

First, there are the fees to consider, which eat into returns. Second, there are usually various conditions attached.

Understanding Caps and Conditions in Structured Notes

In the small print, you’ll learn more about what the note actually offers. For example, the prospectus might state that the index cannot fall by more than 25%. That means if it does, your principal is no longer protected. Downside protection can be called a barrier or buffer. A barrier implies that you’ll lose everything if the index moves below the specified level. A buffer, on the other hand, means anything over the threshold will be forfeited. So, using the example above, if the index was down 50%, then the note would be down 25%.

Gains can be capped, too. The prospectus may state that if the index rises by more than 25%, you’ll only get the principal back and forgo any gains.

Impact of Foregoing Dividends in Structured Notes

Another major downside is that dividend payments aren’t included. If you were investing directly in the S&P 500 via a mutual fund or ETF, you would be reinvesting those dividends over the 18 months. This is a huge deal.

For example, in 2021, the S&P 500 generated a total return, including dividends, of 28.41%. Strip out the dividends being reinvested, and that return falls to 26.61%. That’s quite a difference and can really add up over time, impacting gains and downside protection on notes with barriers and buffers.

The Bottom Line

Structured notes may seem attractive for their customized returns, but they often come with high fees, limited liquidity, and capped upside potential. You may also forgo dividends, reducing your overall returns. These products carry significant credit risk; if the issuer defaults, investors can lose their principal. Because of these drawbacks, structured notes may not suit most investors. If you still choose to invest, you should carefully evaluate the issuer’s creditworthiness and fully understand the product’s terms before committing funds.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial professional to determine a suitable investment strategy.