Understanding structured notes​

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29 Oct 2018 | 9 min. read

Learn how structured notes work, their risks and things to note before you invest.

Key takeaways

  • Most structured notes are not principal-guaranteed.
  • Be prepared to have your money tied up for a set period of time.
  • Redeeming your investment before maturity may not be possible, or could come with substantial cost.

What are structured notes?

A structured note is a debt product whose return is linked to the performance of one or more underlying assets or benchmarks. It may be the interest that is payable on the structured note and/or the principal repayment, that is linked to the performance of the asset or benchmark.

It is a complex product and there are other factors which can affect a structured note’s performance. For example:

  • The credit risk of the issuer as well as the credit risk of various counterparties of the issuer
  • Changes in the value of any collateral provided

If the asset or benchmark underperforms, you may suffer a loss on your returns or even principal invested.

While some structured notes may attempt to preserve the value of the capital invested by providing collateral, there is no guarantee that the principal amount invested will be returned to you.

Structured note vs. structured deposit

Structured note investors may potentially lose the whole amount invested in a structured note. But if you invest in a structured deposit, you will at least receive the principal amount deposited on the maturity of the structured deposits (subject to the credit risk of the bank).

Underlying assets or benchmarks

The underlying assets or benchmarks are sometimes referred to as reference assets or reference benchmarks.

These assets or benchmarks may include:

  • Market indices
  • Equities
  • Interest rates
  • Fixed-income products
  • Foreign exchange rates
  • Commodities prices
  • Any combination of these

There are also structured notes with returns linked to two or more reference assets or benchmarks (for example, the interest amount and/or principal repayment are dependent on both the creditworthiness and the share price of a group of companies).

Note

Structured notes are Specified Investment Products (SIP). It is important that you read and understand the Product Highlights Sheet and Prospectus to understand the product’s features and risks.

Types of structured notes

Here are some types of structured notes that could be available:

Equity-linked

  • Return may be linked to a single share, or a basket of shares, or to an equity index (for example, the S&P 500) or a basket of indices.
  • In some equity-linked notes, the investor may receive shares instead of cash at the time when the principal is to be repaid.

Interest rate-linked

  • Return may be linked to a specific floating interest rate (for example, the Singapore Interbank Offered Rate).

Credit-linked

  • Return may be linked to the occurrence of a "credit event" (for example, if a specified entity (or entities) becomes insolvent or defaults on its loans); and/or to the credit risk or falling market value of any collateral.

Currency-linked

  • Return may be linked to a reference currency pair, e.g. USD/Euro.

Commodity-linked

  • Return may be linked to a basket of commodity related stocks or indices.

Read the Product Highlights Sheet and Prospectus carefully to understand the conditions affecting interest or principal payments. Do ask questions and ensure that you understand the information in the documents before deciding whether to invest in the structured note.

Returns from structured notes

A structured note is a debt obligation of the issuer of the structured note. The issuer of the structured note usually pays interest or returns to investors during the term of the notes.

The interest paid may be a fixed coupon or calculated according to a formula which is linked to one or more underlying reference asset(s) or benchmark(s).

Why invest in structured notes?

Structured notes often offer investors potential returns that are higher than interest rates offered on traditional deposits. They may even offer the potential for capital appreciation.

But such returns or capital gains are dependent on the performance of the underlying reference asset(s) or benchmark(s), which in turn exposes the investor to a greater variety of risks than a traditional deposit would.

What’s the most you can lose?

Most structured notes are not principal-guaranteed. You may lose all or a substantial amount of the money you invested in certain situations, which are described in the Product Highlights Sheet and Prospectus.

The principal repayment or the interest payable, or both may be linked to the performance of an underlying asset or benchmark. If the asset or benchmark underperforms, you may suffer a loss on your returns and the principal invested.

Your return may also be affected if your structured note is redeemed early by the issuer, or for other reasons specified in the prospectus for the structured note.

Checklist

Are structured notes suitable for you?

Investing in structured notes may not be for everyone. Before you invest, check that you:

  • Want potentially higher returns BUT are also prepared for variable returns which include the risk of losing all or a substantial part of the money you invested.
  • Understand how the returns are calculated or are clear about the factors and scenarios that can affect returns.
  • Understand the risks associated with the structured note. Structured notes may use derivatives to hedge risks or to improve performance. Investors should be aware of the risks associated with the use of derivatives, including the risk that the provider or counterparty of the derivative defaults.
  • Understand the full extent of the credit risks associated with the issuer, as well as risks associated with any assets referenced in the note.
  • Are prepared to leave your money tied up until the maturity date of the note or do not have short term needs for the money.
  • Are prepared for your investment to be redeemed earlier, whether at the issuer’s option or for other specified reasons. An early redemption of the structured note may result in you losing all or part of your original investment.

Do find out as much as you can about the products on offer and understand the risks involved before you part with your money.

What are the risks?

An investor will lose money if:

  • The underlying asset or benchmark underperforms, e.g. if the price, value or level of the underlying asset or benchmark does not move in the direction and/or by an amount sufficient to produce a return under the structured note.
  • The issuer of the structured note defaults on its commitments under the structured note.

Structured notes are usually embedded with derivatives such as options or swaps. These instruments provide the link between the note’s overall return and the performance of the underlying reference asset or benchmark.

While structured notes may offer higher potential returns, the investor takes on greater risks when investing in such products. The swap or option involves a contract between the issuer of the structured note and another institution (the counterparty). Note that risks arising from the derivative instruments, including the failure of a counterparty to meet its obligations, may be passed on directly to the investor and may result in the total loss of the original investment amount.

Here are some commonly available structured notes and a description of the key market risks involved:

Equity-linked
  • As returns depend on the performance of the underlying asset (e.g. underlying share, basket of shares, equity index or basket of indices), the risk to you is that the value or level of the underlying asset does not move in the direction and/or by the amount you anticipated.
  • Where the returns are linked to more than one reference asset (e.g. a basket of shares), the returns may not be based on the average of the components of the basket.
    • For example, the formula that determines the returns of the note may give greater weight to the changes in the value of the worst performing share.
    • In such cases, investors should be aware that a larger number of reference assets in the basket may actually increase the overall risk of the product.
  • The issuer may also cap returns, or exercise its right to cap returns if the asset performs far beyond expectations. With returns capped, you bear the risk of foregoing potentially higher returns from investing directly in the underlying share or basket of shares.
  • If the structured note pays you in the form of shares instead of cash, you may end up owning the shares (paying for the shares) at a price that is higher than their current market price.
Interest rate-linked
  • Your returns may depend on the direction and/or amount by which interest rates move.
  • You are exposed to the risk that interest rates do not move in the direction or by the amount you anticipated.
Credit-linked
  • Your returns are exposed to the credit risk of specified entities and to the credit risk or market value of the underlying collateral, if any. In some cases, you may lose all, or substantially all, of your original investment amount.
  • An investor of credit-linked notes should be able to assess the likelihood of a credit event occurring to the specified entities as well as the entities that constitute the underlying collateral.
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General risks of structured notes

In addition, various risks that apply generally to structured notes are listed below. Take note:

  • These events will trigger an early (mandatory) redemption of the notes. You may lose all or a substantial part of your original investment.
  • There may be transaction or unwinding costs associated with early or mandatory redemption, which could adversely impact the amount you receive.

Credit risk of issuer

The issuer may be a special purpose vehicle (SPV). Investors must be comfortable with the assets backing the SPV.

The issuer’s failure to make a payment when due is an event of default.

Derivative counterparty defaults


Derivative counterparty fails to make payments due under the derivative contract with the issuer (which may be a swap or option), e.g. if it is insolvent or becomes bankrupt.

If the derivative counterparty defaults, the issuer will not receive any payments under the derivative contract. It may, in turn, be unable to meet its payment obligations under the notes.

Events adversely affecting the value or performance of the collateral

The collateral may lose value.

If other parties (e.g. the swap counterparty) have a right to the collateral before investors, and/or the collateral’s value has fallen a lot, investors may not recover much.

Other risks and factors to watch out for

Liquidity - As an investor, you need to consider whether you might need access to the money you invested before the maturity date. You would also need to know who to approach should you wish to sell the structured note or get a quotation on the value of the structured note.

Selling before maturity - Any sale of the structured note ahead of maturity may result in a partial loss of your return, your principal, or both.

Reinvestment risk - This arises if the structured note is called or redeemed early and you may have to reinvest the proceeds at less attractive rates.

Inflation - You should also be aware that inflation may erode the returns on your investment.

Early redemption

Many structured notes allow the issuer to redeem or “call” the notes before maturity. When this happens, the notes would normally be redeemed in full.

If an early redemption takes place, you may face reinvestment risk and loss if you are unable to reinvest the principal received at equally attractive returns.

The structured notes may also be redeemed early if:

  • There is an event of default e.g. if the issuer fails to meet payment obligations under the structured note
  • Taxes are imposed on the issuer or on payments from the note
  • An extraordinary or force majeure event occurs (these are described in the prospectus for the note)
  • The market value of any collateral falls and is insufficient to secure any or all obligations under the structured note.

In these circumstances, you may lose all or part of the amount you initially invested.

Fees and charges

The issuer may charge a fee for the management of the reference assets of the structured note and for the hedging of the risks relating to the changes in value of such assets.

A list of all such fees and expenses, which are usually payable out of the returns generated by the reference assets, should be disclosed in the prospectus for the structured note.

If the structured note is traded on an exchange, the trading of the note will incur clearing and trading fees, as well as commission fees imposed by individual brokers.

Documents you should receive

If you are offered a structured note, you should receive a prospectus and Product Highlights Sheet.

Prospectus

Issuers who offer structured notes to retail investors are required to provide a prospectus to investors. Read the prospectus carefully to understand the details of the offer, information on the issuer, risk factors, and the terms and conditions of the structured notes.

Product Highlights Sheet

In addition to the prospectus, the issuer should also provide you with a Product Highlights Sheet (PHS). The PHS is a short document which highlights key features and risks of the structured notes, and usually incorporates diagrams such as graphs and flowcharts to explain the structure or payoffs of the structured notes.

Please note that the PHS does not replace the prospectus. It is important to read the prospectus before deciding whether to purchase the product.

Checklist

Key questions to ask before buying a structured note

When choosing a structured note, consider the following:

What are your financial goals and needs?

Assess your needs and goals, objectives, personal circumstances and risk profile. See: What to ask before buying an investment product

Do you understand the structured note?

Find out more about the structured note you are considering:

  • Ensure that an investment in the structured note is in line with your own investment objectives;
  • Ensure that you understand the factors that will impact your returns; for example, are familiar with the underlying financial asset and are comfortable with the exposure or market view you are taking
  • Ensure you understand all the risks and are comfortable it matches your own risk profile; know when you can lose all or a substantial part of your capital
  • Are comfortable with the credit risk of the issuer of the structured note
  • If there is collateral, know what assets are in the collateral and whether you comfortable with this;

How does it compare with other investments?

Find out about alternative investment products and compare their risk-return profile and features with the structured note that you are interested in. Always ask whether the addition of this product to your investment portfolio will expose you to more risks than you are comfortable with.

See also:

Last updated on 07 Nov 2018