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Difficulty Level: Advanced

Do note that this article is most relevant for Priority/Private Bank clients.

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1) What are Equity Structured Notes?

2) Common types of Equity Structured Notes

3) Considerations to note before deciding to invest

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InvestQuest’s View: Structured Notes are complex products for sophisticated investors. They are not without potential benefits, but it is crucial to take time to learn about them and the risks involved – before investing. Do note that the guide below is made on generalizations and may not apply to the specific product that your bank is offering. Do read the term sheet and ask a lot of questions!!

Access to Structured Notes is typically limited to Private Banking and Premier Banking clients. Aside from increased access to a wider range of investment solutions, there are other benefits of having a Private Banking Account which we cover in this article.

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Disclaimer: The guide below is meant for information purposes only. The information should NOT be relied upon for making any investment or financial decisions. We are also not recommending any particular product. We highlight that Structured Notes are a particularly customizable product and the guide may not be relevant to what is being offered to you.

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(OPTIONAL) What Are Structured Notes?

Structured Notes are instruments that allow an investor to express a very specific market view or to achieve a preferred investment payoff. For instance, maybe you think the market is going to go up, but not by that much. Or maybe you think the market is going to go down and you don’t want to lose money, but you also want to participate on the upside in case the market goes up… In short, Structured Notes are complex vehicles that are “structured” to offer different payoffs depending on how underlying stocks/forex/bonds/interest rates perform.

Usually, it takes at least $100K to buy a Structured Note. As a result, Structured Notes are typically marketed to high net worth clients of a Priority Bank or Private Bank.

In this article, we’ll look at Equity Structured Notes. We may look to explore FX, credit and interest rate structured notes in subsequent articles.

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1A) What are Equity Structured Notes?

In a nutshell, Equity Structured Notes are instruments that give you different payoffs depending on how the underlying stock(s) performs. E.g. if a stock ends above a certain price, you get payoff X. If it ends below that price, you get payoff Y.

This certain price is known as a STRIKE or STRIKE PRICE. You can think of it as a pivot upon which the outcomes are judged. It is usually below or equal to the stock’s initial price (the stock price when the note was structured), but structured notes are highly customizable and it is possible for the strike to be above the initial price.

I mentioned payoff X and payoff Y. These vary widely according to the type of structured note. And sometimes there could be a third or fourth payoff, depending on other conditions as defined by the structured note.

Some notes are structured for bullish investors. In those cases, the investors usually prefer payoff X, when the stock ends ABOVE the strike price. Sometimes, payoff X may be receiving a yield in cash. Sometimes, payoff X may be getting the stock’s price return (in % terms). Sometimes, it might be getting an upsized version of the stock’s price return. Etc.

With regard to payoff Y, when the stock ends BELOW the strike, what it actually entails varies widely too. However, keep in mind that for many types of bullish notes, payoff Y actually involves buying the underlying stock(s) at the strike, using the money that you had paid for the structured note. So just to recap, the underlying stock is used to determine the payoffs of the structured note, and sometimes one of the those payoffs involves buying the stock.

It is also possible to structure bearish notes. In which case, payoff Y, when the stock ends BELOW the strike, would usually be more attractive.

Note that most of the structured notes featured in our guide are neutral to bullish notes, because these are the most commonly traded ones.

You could think of Equity Structured Notes like horse betting, and stocks as the horses in the race. For all horse betting games, your payoffs naturally depend on how the horses race. But different betting games have different kinds of payoffs for the same event. For instance, some may give you a fixed amount if the horse you choose wins. Some may give you a variable amount if the horse wins, depending on how much the horse has won by. For some, you won’t lose anything if the horse loses and you may get a return if the horse wins, on the condition that you stay all the way till the last race. Etc. (Continuing the metaphor) some of these betting games will require you to buy the horse if said horse completes the race slower than a specific timing.

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1B) Categories of Equity Structured Notes

There are three big categories of Structured Notes.

• Yield Enhancement Notes
  • These offer you a yield whether or not your stock ends above/below the strike. BUT, if the stock ends below the strike, the result is that you’ll usually have to buy the stock at the strike.
  • They usually cater to yield-seeking investors who are neutral to slightly bullish on the stock market.
• Participation Notes
  • These notes offer you a return that is conditional on the stock surpassing the strike. In some cases, the notes offer an upsized return (e.g. the stock rallies 10% but your return for the structured note is 15%).
  • They usually cater to investors who are bullish on the stock market, who want amplified returns to stock price movements or an element of downside protection.
• Principal Protected Notes
  • These notes usually give back what you paid (i.e. your “principal”) in the event the stock ends below the strike. However, if the stock ends above the strike, you will get a return.
  • They usually cater to more conservative investor profiles.

Below, we’ll be showing you what the payoffs are for the most common equity structured notes in each of these categories.

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1C) Before we begin the next section…

First, note that we have made generalizations for the tables in the following sections. Structured notes are highly customizable and their payoffs may not be the same as what we suggested even though the name is the same. You have to look through the terms carefully. Also, the names used for such notes may vary across different countries and banks.

Second, oftentimes structured notes may be based on a “basket” of stocks instead of a single stock. According to our horse betting metaphor, it’s like betting on how three horses do vs. betting on how a single horse does. For the three horses, the bet may be whether the slowest of the three horses comes in better than a certain time. This is known as a Worst-Of Structured Note. For simplification, our guide for Structured Notes is based on the assumption of a single underlying stock.

Third, remember that the payoffs are generally based on how the stock has performed vs the strike AT THE END of the note’s duration. That’s how we have structured our guide. However, some notes are fancier and have more kinds of payoffs linked to conditions that apply to how the stock has performed DURING the life of the note. These are typically Knock-In or Knock-Out conditions. To avoid confusion, we have spent less time on these in this guide. Instead we will write about them in individual articles on the different types of Structured Notes at a later date.

Fourth, take note that there are other risks associated with Structured Notes that we haven’t detailed in the guide. For instance, there’s counterparty risk. If Credit Suisse offers the Structured Note but then Credit Suisse goes bust, you might not get the payoffs you signed up for.

Fifth, you have to know these three terms!!

• Principal = What you pay when you purchase the Structured Note
• Initial Price = Where the stock price was when the terms of the Structured Note were set.
• Strike Price = A specified stock price that determines the different outcomes of the Structured Note.

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2) Common types of Equity Structured Notes

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2A) Yield Enhancement Products

Recall that Yield Enhancement Products offer you a yield whether or not your stock ends above/below the strike. BUT, if the stock ends below the strike, the result is that you’ll usually have to buy the stock at the strike.

They usually cater to yield-seeking investors who are neutral to slightly bullish on the stock market.

The most common types of Yield Enhancement Products are the Equity-Linked Note (ELN) and the Fixed Coupon Note (FCN).

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2B) Participation Notes

Recall that Participation notes offer you a return that is conditional on the stock surpassing the strike. In some cases, the notes offer an upsized return (e.g. the stock rallies 10% but your return for the structured note is 15%).

They usually cater to investors who are bullish on the stock market, who want amplified returns to stock price movements or an element of downside protection.

The most common types of Participation Notes are the Digital Coupon Note (DCN), the Bonus Coupon Note (BCN), and the Airbag Booster.

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2C) Principal Protected Notes

Recall that Principal Protected notes usually give back what you paid (i.e. your “principal”) in the event the stock ends below the strike. However, if the stock ends above the strike, you may get a return.

They usually cater to more conservative investor profiles.

We show what a typical Principal Protected Note looks like.

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2D) A summary of common Structured Notes

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3) Other considerations to note before deciding to invest

Knowing if you are crossing any dividend ex-dates. As a stock crosses its dividend ex-date, you can expect the stock price to decline in line with how much dividend was paid out. This should be taken into account when considering if the note’s strike price and yield is attractive or not.

Knowing if you are crossing any earnings announcement dates. Earnings announcements pose an event risk and may result in extreme stock price movement. For yield enhancement notes such as ELNs and FCNs, the investor’s upside is capped to the yield. Hence, the investor takes on an asymmetric risk-reward when encountering event risk, having the downside if the stock price plunges but not participating on the upside if the stock soars. You should factor in such risks when considering if the investment terms of the Structured Note are attractive enough.

Compared to Structured Notes that reference a single underlying stock, the risk is much higher for Worst-of Notes that reference the worst-performing stock (within a basket of stocks). This risk increases if the correlation between the selected stocks in the basket is low, which may be because the stocks in the basket are from different industries. There may also be the case (albeit unlikely) that one of the stocks in the basket has a trading suspension, resulting in your principal being “locked up in the Structured Note” till the suspension is lifted.

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InvestQuest’s View

Structured Notes are complex products for sophisticated investors. They are not without potential benefits, but it is crucial to take time to learn about them and the risks involved – before investing. Do note that the guide above is made on generalizations and may not apply to the specific product that your bank is offering. Do read the term sheet and ask a lot of questions!!