Structured notes terminology FAQ
In below FAQ we explain some of the most frequently used terms found on structured notes fact-sheets.
The theme and structure of the note often shows in the title of the structured note.
If the note meets the conditions for coupon payment the investor receives this yield, usually expressed as an annual percentage. In all cases the investor is to scrutinize the note seriously for suitability. A note which offers a high yield percentage involves more risk for the investor and deserves more scrutiny.
The basket of underlying assets is vital for the success of a note. The combination of assets determines the yield of the note. The type of underlying asset further adds to this. For instance, a basket that consists of four indices can be more attractive than a basket that consists of four equities. Equities are more volatile than an index and thus offer a better yield potential, but also a higher risk of failure.
Less is more
Less is more when it comes to baskets. The reason is simple; the more components a basket contains, the more elements of risk and return are present. By adding more components to the basket the issuer still can present an attractive yield, even when the market is calm. However, each additional component adds to the risk of one of the components breaching the barrier. When markets are more volatile issuers can obtain more attractive returns per component and thus require less components per basket to obtain an attractive yield.
The barrier is a very important aspect of any note. The most common barrier level equals to 50% of the strike price. However, to increase the yield on a note the issuer can also set higher barriers of 60%, or even 75% from strike price. Such reduction in maturity protection is cheaper to purchase for the issuer, therefore leaving room for higher yields. It is vital to assess the price volatility of every underlying asset, in combination with the recent market performance, and determine if the barrier level is sufficient.
“Worst-of” or “Combined” basket
This is a very important detail clients and advisers easily overlook. The most common structured note uses a ‘worst-of’ basket. This means that the performance of the entire note depends only on the worst performing individual component of the basket. If your basket consists of correlated assets this would be the preferred structure.
A less desirable structure would be the ‘combined-performance’ basket. Here the performance of all underlying assets is combined and then measured. Let’s look at an example, if your basket contains four equities and the barrier is 50% it only requires a 12,5% drop across all equities to hit the barrier. Such notes seem secure at first sight due to the high barrier, but are not secure at all, especially if the performance of the equities correlates strongly!
“European” or “American” barrier
This is an important technical detail that affects the capital protection at maturity. At maturity the final values of the underlying assets are compared to the start price, called the strike price. The European barrier type of notes will only observe the barrier at maturity. Whatever happens to the assets’ value during the life of the note is irrelevant. On the contrary, the American style barrier is observed throughout the entire term of the note. If, for instance, one of the components of a five year note breaks the barrier in year two the note immediately loses its capital protection. The final value at maturity now depends solely on the worst performing component. As you can imagine, American-style barriers are riskier than European-style barriers.
The observation frequency effectively determines how many chances the note has to “auto-call”, or pay a coupon. This frequency affects how likely you are to get your coupon and capital back. Markets constantly move, so a more frequent observation date, such as quarterly, is preferred to semi-annual or annual observation dates.
Sometimes the term “Snowball Coupon” or “Memory Coupon” is found on the fact-sheet. This means that if at an observation date the note does not meet the coupon payment requirements, this coupon carries over to the next observation date. Once the coupon payment requirements are met at an observation date in the future, all previously missed coupons are paid out too. In other words, the investor obtains more chances to receives the expected return on his note, even if there is a market downturn during the term of the note.
We hope our FAQ on structured notes helped you to become more familiar with the terms often used on structured notes fact-sheets. Shoreline offers structured notes to clients via its many partners. If you have any questions, or would like to receive regular updates on structured notes please contact us. Follow this link for additional reading material on structured notes.