Understanding Structured Notes
Structured notes are a debt obligation with an embedded derivative option, normally based on an underlying basket of equities.
Even if you’re the most investment savvy of individuals, you probably stopped and reread that description. And quite rightfully so.
When you buy a house, it is normal for you to secure a mortgage from the bank, guaranteed against that house. A structured note is the same, but the other way around. The individual client is the lender and the bank is the borrower, but your money isn’t secured against a physical asset. Your money is effectively secured against equity markets.
It is simply an IOU issued by an investment bank to an individual person. You are, however, only rightfully due the “yearly interest” and your capital back if the terms and conditions of the IOU are fulfilled.
Is the bank you loaned money to creditworthy and too big to fail? This is not the correct question to ask. The correct question is: can I get the same return elsewhere, without taking as much underlying risk and without having my money being tied up for as long?
Most notes are marketed in the same way. Who doesn’t want downside capital protection, with guaranteed upside potential? However, clients’ capital is often only protected to a certain point and growth is capped to a limit. This ultimately means that in good market conditions they are poor value, due to the bank taking a slice of the profits, and they can be dangerous in bad market conditions.
Equity markets can be volatile at times and one of the great advantages of stocks and daily traded product is that you can sell at any point. With a structured note you don’t have that luxury, so it almost defeats the purpose. We are now seeing new levels of volatility in the stock markets and as such even the most cautious structured notes will now have new challenges and become riskier.
Not all notes are bad, however arguably they are often far too complicated for individual clients to understand and mainly intended for sophisticated investors. Structured notes often look simple on the surface but can be very complex. And while your capital may be backed by a big bank, it is ultimately at the whims of the markets, which we all know is under control of no single person.
The most important question for clients to ask is: is the risk reward ratio in my favour? Would you rather lend your money against the stock market or have your money backed by physical assets?
At Berkeley, our clients’ capital is backed by physical real estate. While our clients may not receive double digit returns, we offer more than just growth. We offer peace of mind and a place where clients can have their capital grow safely over time short to medium terms.
Our clients place capital in tangible physical assets and businesses where value creation is implemented by our in-house experts.