What are Structured Notes?

Feb 28, 2024 | Investment

Allison Moore, a member of the Hutchinson team, welcomes viewers to a discussion with Todd Walker, Senior Portfolio Manager at Hutchinson Family Offices.

Todd sheds light on using structured products in client portfolios, emphasizing their role in monthly income with defined downside protection. He introduces the concept of income notes, providing a detailed example of a three-year note linked to the S&P and the Russell, highlighting the potential returns and downside protection mechanisms. Todd also discusses the introduction of dual-directional growth notes for clients seeking growth potential.

The discussion covers the risks associated with structured products, including issuer credit risk, market risk, and opportunity cost. Todd explains why Hutchinson utilizes structured products, citing challenges with traditional portfolio models during market pullbacks.

The video concludes with reassurance about the long-term perspective of structured product investments and an invitation to share the information with others.

Video Transcript:

 Allison Moore:

Welcome, and thank you so much for joining us here today. If you are not familiar with me, my name is Allison Moore and I work directly with our amazing team here at Hutchinson to help bring you information that is helpful and relevant to the current market. Today, I have the pleasure of being with Todd Walker. Todd is our Senior Portfolio Manager and is in the day to day management of our client portfolios. And today we are going to talk about structured products and how they help diversify our clients and set us apart at Hutchinson from others.

So, Todd, how are we using structured products in our clients portfolios these days?

Todd Walker:

Well, thank you, Allison.

The way we positioned structured products in our clients portfolio is we’re trying to accomplish above average monthly income for our clients with defined potential downside protection. And that is what we refer to as our income notes. Our number one goal is to provide defined downside protection. Now, once this piece has been achieved, we then ask ourselves how much income can we generate with the minimum amount of predetermined risk? We marry these concepts together, and typically we’re able to provide a 9 to 10% annualized returns on those notes, with the probability that one individual note might fall below that 40% barrier at a very low rate, less than 10%. Due to that, albeit low possibility of failure, we will ladder the notes with different maturities in order to make our, risk levels go even lower for our clients.

Allison Moore:

Gotcha. So who would you say these these structured notes are for?

Todd Walker:

Structured notes that we work are designed for who we classify as sophisticated investors. The term doesn’t come from the investors market knowledge, but rather the goals the specific investor has. For instance, above average growth with downside protection or above average income with downside protection. And due to the complex nature of, structured products are only available through the use of a financial advisor or through a firm like ours. And they often come with a set minimum investment.

At HFO, we not only have access to these type of products, but more importantly, we have the ability to individually customize our structured products to fit our client’s specific needs. And that’s this is exactly what structured products are designed to do. They provide defined incomes that interest rate or uh, percentage per month with a predetermined downside protection risk, which is the 40% in our case. And this is why we feel comfortable deploying them in our clients portfolios.

Allison Moore:

So you mentioned that they were a little bit complex in nature. And for those of us that are a little bit more visual, can you give us an example of how the structured products work?

Todd Walker:

Yeah. Let’s take a minute to go through some individual examples and different scenarios of an income note and a growth note. You can see in this particular, example where looking at a three year note and we normally do 3 or 4 year notes. The underlying are the S&P and the Russell. And each each week I go out 2 to 3 times a week and get pricing from the different, investment companies. And I give them the same parameters, and they come back to us with different, rates coupons that our clients will get on an annualized basis. And I’m able to cherry pick these and try to come up with the best particular situation for our clients to help them achieve their goals. The principal on this particular note is down 30%. Like I said, we normally do 40 and it’s auto callable, which means either at a three month period or after six months, that if were traded for one penny more than what we paid for them, then we will be called out and we’ll have to look and replace that note. And for this particular parameters, they’re going to pay us 8% per year on a quarterly basis.

So let’s look at the first scenario. In the first scenario we go along for the entire three years. It stays within our barriers. And you can see the barrier 30% downside protection in this illustration. And where the zero is that’s what we pay for the notes. It stays within these parameters. So we get all of our coupons which are 24% plus the return of principal with 100% of our money back.

And the next example you can see in quarter five, the note is now trading for more than what we paid for it. So in this instance our clients would get their coupon for that quarter. Plus they would get 100% return of principal. So over the five quarters in this illustration, we’ve got 10% coupon payments plus 100% return of principal.

And the next scenario you can see in quarter six we went below our barrier. And so in that particular instance, we will not get a coupon payment for that particular quarter. And then we continue to see the next quarter. We’re back above the barrier. So we continue to get coupon payments. So at the end of the three year period, we would have gotten 22% from coupon payments and 100% of our principal back because we finished above the band.

And the last scenario you can see at the end of the term we finished below the barrier, the underlying index, the worst one was -33%. So at that point we typically would be priced at whatever the note was pricing for at that point. Uh, so you can see it’d be -33%. But because we received 20% in coupon payments, we would only have a 13% loss on principal.

Uh, now, we’ve been doing this almost three years and thus far, knock on wood, we haven’t had any notes breached the barrier. If we ever had any notes coming close, I would typically go in, buy the note back, or have the note bought back from us, from our clients and go back and reprice and go back into the market at better levels.

Todd Walker:

Now, in 2023, the market started, coming back and started doing well. So we decided that we wanted some growth potential in the notes and not just income, so we started utilizing some dual directional growth notes. And in these particular, investments, we have one underlying we usually use the S&P 500. The term is two years. We normally go out two and a half. And you can see in this particular example we have 100% upside potential. And 100% downside with a performance cap of 24%. And the last factor is is we also had a downside protection of -20% to the market.

And you see in the first scenario, at the end of two years, the market returned 30%. Since we have the 24% cap, our clients would all get 24% plus 100% return of the principal in the next scenario. At the end of two years, the S&P was up only 20% below our cap of 24. So we fully participated in the upside of the S&P. So we got 20% return plus return of capital of 100%. And then the unfortunate situation at the S&P is negative at the end of two years.

And you can see in this example it’s -16%. Since we had the 20% protection buffer, our clients would receive a 16% return plus 100% return of principal. And the last scenario the S&P was down 32% in two years. We were buffered and protected down for the first 20% of that 32. So our clients ended up with a loss of 12%. Now that doesn’t sound good. A loss is always not that great, but this is money that would have been in equities anyway. And so I would a lot rather be down 12 instead of 32% in that case.

Allison Moore:

Absolutely, so, risks are associated with these structured products?

Todd Walker:

Well that’s a good question. There’s three primary risks. The first is issuer credit risk. And that’s the risk that in a crisis the issuer of a note becomes insolvent. So think of JP Morgan going under or Bank of America going under.

So one of our first screens is to make sure that we only use, uh, credit, you know, banks that have very good credit ratings and low potential default risk.

The second is market risk. And due to the investments being linked to different indexes in the market, the investors are taking on the risk of the underlying indexes the notes are linked to.

And then finally there’s opportunity cost. And due to the fact that these investments are designed to be illiquid, they can underperform other investments over a set period of time. So that’s that’s the main risk associated with these investments.

Allison Moore:

Gotcha. So why would we utilize structured products now.

Todd Walker:

Good question. Typically portfolio managers have relied on the 60 over 40 model, the balanced model, the golden ratio between stocks and bonds to allow portfolios to have upside opportunity while being able to dampen the downside exposure. Should we pull, you know, should we experience a market pullback. Well unfortunately during the last bull few pullbacks, the global financial crisis, the Covid 19 and years like last year in 2022, we’ve started to see stocks and bonds move in the same direction. And so thus we’re not able to provide protection that we need in a in a pullback here.

For instance, in 2022 the S&P was down between 19 and 20%. But the bond index was also down between 14 and 15%. So really there was no place to hide. And the structured notes that we have used gives us the ability to get above average returns by providing a higher level of protection on our portfolios. And so, you know, our main goal is to try to protect the hard earned assets that our clients have grown over time because they entrusted us with those. And what I’m trying to do is eke out any kind of return I can and then, but protect them and make sure we don’t take on too much risk in the portfolio.

One of the other questions before we finish is I get a lot of questions on the pricing of these notes, and whenever we buy a note, we it’s going to price on your statement at $100 a share. As those underlying indexes go up and down, you’re going to see that number move up and down. Well, just understand we are in these for the long term. They’re either going to have two different conclusions happen. We’re either going to get caught out early which we’re having a lot of that happen now.

Typically uh, average own industry average on a note being called is about eight months. That’s going to vary based upon, you know, different market conditions. But our primary number that we’re worried about is what’s the worth or what’s the value or price of that note on the day it matures. And so that’s the main thing that we’re concerned about. So you’re going to see the prices fluctuate on your statement. Don’t be that concerned But if you do have questions at any time please, you know, feel free to give me a call and I can walk you through everything that we are, uh, watching.

And believe me, we are looking at these on a daily basis, and we’re trying to make sure that we put our clients in the best position to be successful and and to help them achieve their goals.

Allison Moore:

Well, thank you, Todd. That was super helpful for just walking us through what structured products are, um, how they benefit our clients. And for you, all these talks are designed to bring you information and education. In the past, you have asked if you can share this information with others who you feel would benefit from it and what we discussed today.

And the answer is yes, you can share it with anyone you think that could bring it could bring some insight or education to.

If you are interested in going into more detail about anything we discussed today, or you have questions about the content we discussed, you can contact our office or book some time with Todd.

As he mentioned, get on his calendar or reach out to us and let us know how we at Hutchinson can help. Thank you again for joining us and we look forward to talking to you soon.

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