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210% upside participation of a stock index AND possible positive returns if the index is down. See how we're doing it. Thumbnail

210% upside participation of a stock index AND possible positive returns if the index is down. See how we're doing it.

Investing

The Best of Both Worlds

As a Financial Advisor, two requests investors often ask of me when helping direct their investment savings are:

1) "Can you help me outperform a market index?"

2) "Can you help protect and/or grow my investment if the market (index) declines?"  


While it's very challenging to meet both of these demands, I'm always managing the balancing act of trying to help clients make money during positive markets while losing less in down markets.  So when I learn of a strategy that can help achieve both of these objectives, I'm willing to present it as an option to suitable investors.  An investment vehicle that can offer this "Best of Both Worlds" scenario can be found with "Structured Products," also known as "Structured Notes."

Previously only available to wealthy investors, structured notes can be a powerful strategy for adding downside protection, enhancing income or participating in market returns. In this post, I'll provide a brief overview on structured notes as well as an example of one particular note offering we recently participated in for select clients.

What is a Structured Product?

A structured product (note) is a type of debt security, issued by any one of the large investment banks, where the return is linked to the performance of another asset, such as a stock or market index. While the majority of a structured note consists of a zero-coupon bond, the remainder is an options package which determines the payout/participation and protection levels. Each structured note has a finite maturity date (however some may be called prior to maturity) and is subject to the credit of the issuer.

Just like there are many different stocks, bonds, and mutual funds -  there are many different types of structured products. For purposes of this article, I will only cover what is referred to as a "Dual Directional Barrier Note" including an example of a recent offering that we participated in for select client accounts.

What are the Benefits of Structured Notes?

Benefits of a structured note include higher potential returns than traditional fixed income securities, enhanced participation of a stock/index price appreciation while also limiting downside exposure.  "Dual Directional Barrier Notes" offer the added benefit of possible positive returns in a declining market environment.

RECENT OFFERING EXAMPLE

Consider the following Dual Directional Barrier structured note investment:HSBC 2.1x Uncapped 5 Year Dual Directional Barrier Note

  • Bank Issuer: HSBC Bank USA, Inc.
  • Term: 5 Years
  • Underlying Exposure: The Least performing of the SPDR® S&P® Biotech ETF (Ticker: “XBI”) and the Industrial Select Sector SPDR® Fund (Ticker: “XLI”)
  • Upside Performance Participation Rate: 210% Uncapped of Least Performing Index
  • 1x positive exposure to the Absolute Reference Return of the Least Performing Underlying if its Reference Return is negative but not less than -30%
  • 1x exposure to any negative Reference Return of the Least Performing Underlying if its Reference Return is less than -30%

Below is a visual payoff chart that shows the potential payoff of this note across four broad market scenarios.

Potential Market Performance ScenarioHypothetical 5 Year Return of Least Performing Underlying (XLI or XBI)Hypothetical Return of Note at 5 Year Maturity DateValue of $100,000 investment at 5 Year Maturity Date
Very Bullish+80%+168%$268,000
Moderate Bullish+30%+63%$163,000
Moderate Bearish-30%+30%$130,000
Very Bearish-40%-40%$60,000

As you can see, the only market scenario (aside from credit risk) in which an investor's investment would depreciate is if one of the two referenced indices is down more than 30% on the five year maturity date. The note holder will actually generate positive returns during the first 30% of losses of the least performing referenced index.

What type of Investor should consider a Dual Directional Barrier Note?

This type of investment would potentially be suitable for an investor who would like to outperform the least performer of the underlying indices and that has a 5 year time horizon.   It would also be suitable for an investor who desires a potentially positive return in the case of the least performing index decline. In this example, an investor who already has portfolio exposure to the Biotech and Industrial Sectors could benefit by considering this as a replacement option for the reasons listed above.

What are the Risks of a Dual Directional Barrier Note?

#1: Credit Risk

If the bank issuer of the note defaults, the entire value of the investment principal is at risk of not being repaid. This is the equivalent risk associated with investing in any other corporate bond. Investing with highly rated banks with strong balance sheets reduces this default risk.  In this example, HSBC USA is rated A2 by Moodys which is considered investment grade.   JP Morgan Chase is a similarly rated bank as of the date of this article.

#2: Liquidity Risk

The maximum benefit of investing in a structured note is usually realized by holding until the maturity date. There is a secondary market but it is limited to broker dealers and their affiliates and distributors. This means that any sales made prior to maturity could be at a discount to the current market value.

#3: Market Risk

Losses are only protected according to the terms of the individual note.  In this case, an investor's principal is at risk if either the SPDR® S&P® Biotech ETF or Industrial Select Sector SPDR® Fund is down more than 30% at the 5 year maturity date.

#4 No Periodic Interest or Dividend Payments

Dual Directional Barrier Notes do not provide interest payments.  Meanwhile, an investor who owned the XLI or XBI exchange traded funds (ETFs) would receive dividend payments.

Why Invest in Structured Notes with a Registered Investment Advisor and Claro Advisors?

While structured notes can be purchased through a number of different financial institutions, there are several advantages to an investor by purchasing through a Registered Investment Advisor who is experienced with these investments.  These advantages are as follows:

Wide Selection & Competitive Pricing

At Claro Advisors, we work with a number of different service providers who offer a variety of Structured Products. These providers have access to a number of different bank issuers which have products that can accommodate a diversity of investor goals and needs.

Many of the service providers we work with use an auction process where banks compete with each other for the best possible client pricing terms. From my experience, "shopping" for the best note and terms almost always provides better client pricing terms.

Furthermore, as a fee based advisor, the notes we buy for investors do not have built-in commissions or sales charges.  This means there is more money working for the client upfront which typically results in substantially better pricing terms. Better pricing can mean more upside participation, more downside protection and/or higher income for income notes.

Knowledge and Experience

Working with an experienced advisor who understands the benefits and risks of structured notes is critical when investing in structured products.  An advisor who is familiar with the history and landscape of offerings is more likely to have relationships that can add the most value. This includes finding and customizing the most compelling note that fits within an investors suitability and risk tolerance profile.

While structured notes are not for everyone, they can provide benefits that investors cannot receive by owning individual stocks, bonds, ETFs or mutual funds. When used wisely, structured notes can provide a more predictable range of investment returns and may be an option for investors who are looking to enhance returns while also receiving partial principal protection.

The HSBC 2.1x Uncapped 5 Year Dual Directional Barrier Note referenced in this article is a completed offering and is no longer available for purchase at the illustrated offering price and terms.  Please review the completed offering document for additional risks and disclosures.

To see a list of our completed offerings including income notes, please click here

Performance figures do not reflect the deduction of investment advisory fees. Client’s return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account; Investment advisory fees are described in the Advisor’s Form ADV Disclosure Brochure.


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