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What Are Structured Notes?

What if your wealth manager told you that an investment product exists that can be custom-built for your investment objectives and offer both market upside participation and downside protection at the same time?

Most retail investors have a hard time believing that such a product exists, and most financial advisors don't understand these simple yet effective products either. Structured notes are one of the strategies that we use at Paragon Capital Management to meet our clients' goals, and below we will help you to understand what they are and how they work.

As a debt obligation issued by investment banks that includes hybrid notes (80-90% fixed income or bond component) and options or derivative components based on the returns of an underlying asset (10-20%), structured notes work in ways that can be used to build an investment portfolio that includes both upside potential and downside protection.

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Structured notes are issued by investment banks, and can come in several different forms. When used correctly in conjunction with a good long-term strategy, these instruments can prove incredibly beneficial. Despite the many benefits that structured notes can provide to a portfolio, many advisors aren't familiar with and don't utilize these types of securities

Paragon Capital Management President & CIO Craig Novorr discovered the potential of wholesale structured notes tailor-made for his clients when he was seeking a way to avoid the drawdowns that many faced during the 2008-09 financial crisis.

He had discovered that massive corrections had been increasing in both occurrence and severity, and wanted to find a way to protect the portfolios of Paragon clients while also allowing them to participate in the upside potential of bull markets between corrections.

Leveraging his decades of experience and connections as a fund manager & institutional investor, Craig created a way to get the world's largest investment banks to build custom-structured notes for his clientele rather than using the Over-the-Counter (OTC) retail products that most utilize.

Structured notes and products are only one of the strategies that Paragon Capital Management, LLC utilizes for our clients, but it is an aspect of our investment philosophy that most investors are unfamiliar with.

Below, we will help you to better understand what a structured note is so that you may grasp how they can power your portfolio by providing principal protection, a beneficial payoff structure that can be tailored to your investment objectives & tax implications and allows you to participate in the upside potential of various markets.

An Insightful Exploration into the World of Structured Notes

For those retail investors whose investing experience has only been in basic mutual funds or equity index funds, the stock market, and perhaps even bonds, it can be difficult to grasp why investment banks would want to sell products that provide so much potential and a payoff structure that requires them to pay more often than not.

To understand why they would do this, you have to have an understanding of the basic components of investment banking. For banks that offer deposit accounts to their clients, those funds provide the ability for the banks to meet the capital requirements of the Federal Reserve, bring in revenue through interest rates on loans that they issue, add liquidity to their balance sheets, and build products based on those deposits and revenue streams.

Investment banks that do not have deposit accounts, however, need a way to come up with the capital that provides the liquidity to participate in their own investment objectives. As an investment bank they still have capital requirements for their operations, and selling structured notes and products provides them with one way through which they can meet them.

These products do provide a significant amount of liquidity for the investment banks, as clients of Paragon Capital Management, LLC are typically ultra-affluent and meet the $1 million minimum investible capital requirement.

Each structured note is built to deliver returns based on the performance of an underlying asset. The asset classes that a structured note is built to track can include any of the following:

  • Individual equity
  • Index
  • Interest rates
  • Currency
  • Commodities
  • Property markets
  • A basket of any of the above

The payoff and amount of capital invested can be pre-determined, and the payoff profile can be built to take advantage of rising, falling, or range-bound markets. Because Paragon Capital Management, LLC works directly with the investment banks to arrange custom-built, wholesale structured notes rather than buying them OTC, each particular structured note is delivered in a form that is tailored to the specific investment objectives of our clients.

Almost all structured notes include four basic components
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Maturity date

The terms may vary, but they typically range from two to six years

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Underlying asset

The reference asset that the note's performance is based upon

Protection icon

Protection

The level of protection that the investor receives if the investment decreases in value at the maturity date

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Payoff structure

The amount that the investor receives back at maturity

Unveiling the Distinct Advantages of Structured Notes Investment

Structured notes may have significant advantages over other types of securities based on the way that they are built - especially when we can have them built specifically to meet our individual client's investment objectives.

The five main reasons that we use structured notes as a part of our investment strategies are:

Downside Protection

The downside protection of a structured note can be structured to provide any percentage of the principal protection, from zero to 100%. A Principal Protected Note provides 100% principal protection. These are well-suited for tax-deferred accounts since the tax implications change from long-term capital gains to ordinary income.

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Maturity date illustration

Accelerated returns

Structured notes can be created in a way to achieve greater performance than even the underlying benchmarks. An Accelerated Buffer Note, for example, will include a "buffer" that provides downside protection as well as an accelerated element that has a payoff structure of over 100% of the performance of the underlying asset.

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Diversification

Structured notes provide the ability to invest in markets or asset classes that may not be available in other structures.

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Mitigating exchange risk

Investing in structured notes may allow you to participate in foreign markets by buying options tied to those exchanges, which eliminates currency exchange risk (the risk that the foreign exchange rates will create an arbitrage that is not in your favor).

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Yield enhancement

Many structured notes are growth notes with no income, but they may also be designed to act as an income note that has the potential for coupon payments that can be far greater than standard fixed-income bonds (municipal bonds, treasury bonds,or corporate bonds).

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An Honest Look at Structured Notes: Understanding Potential Risks

All investments have some level of risk, and structured notes have their own. The four primary risk factors that need to be considered for structured notes are:

Risk Management strategies For Structured Note Investments

Although the risks listed above should be a part of your equation when considering a structured note, there are risk mitigation strategies that can be implemented. Depending on the individual investors and their needs, Paragon Capital Management may implement some of the following risk mitigation strategies:

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Laddered portfolio

A laddered approach involves buying multiple structured notes at various initial prices, with different underlying assets that are issued by different financial institutions, each maturing at different dates. Using multiple institutions helps to reduce the credit risk, and the staggered maturities help to mitigate the risk that the market moves against you at your maturity date. Using multiple maturities also creates a stream of cash flow throughout the year rather than all of your structured notes reaching maturity on the same date.

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Specific date

If it is known that a client will need a specific amount of money on a certain date, a structured note can be created that matures on or before that date while also protecting against capital losses through downside risk protection measures.

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Research

Credit risk can be reduced by researching the issuing financial institution. Knowing and tracking the credit and creditworthiness of the issuer is critical, as is being aware of the market & geopolitical risks that could potentially affect the institution prior to maturity.

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A Closer Look at the Diverse Types of Structured Notes

Types of Structured Notes: Exploring Options For Investors

The fees and availability of the structured note depend on who sells it, but there are also a handful of different configurations that a structured note may have.

Comparison table:

Structured Note Type
Downside Protection
Upside Potential
Risk Level
Tax Treatment
Investor View

Buffer

Protects principal within a specified buffer range

Limited by the buffer range

Moderate icon

Moderate

Dependent on Holding Period

Cautiously optimistic

Barrier

Protects principal within a specified barrier range

Depends on barrier breach

Higher Icon

Higher

Dependent on Holding Period

Moderately bullish

Accelerated Buffer

Protects principal within a specified buffer range

Upside participation up to a capped percentage

Moderate icon

Moderate

Dependent on Holding Period

Moderately bullish

Capped

Protects principal within a specified range

Capped upside participation at a certain percentage

Moderate icon

Moderate

Dependent on Holding Period

Moderately bullish

Uncapped

Protects principal within a specified range

Unlimited upside participation

Higher Icon

Higher

Dependent on Holding Period

Bullish

Principal Protected

Full protection of principal

Limited by market performance

Low Icon

Low

Dependent on Holding Period

Risk-averse

Digital Coupon

Limited downside protection within a buffer range

Digital payoff if asset is at or above predetermined level

Moderate icon

Moderate

Dependent on Holding Period

Neutral to moderately bullish

Key Factors Influencing the Terms and Pricing of Structured Notes

The structured note is built from two components. The first part is a zero-coupon bond, which is a bond component that has no income note. Because they are issued based on the future value of an income stream, these are sold at a discount to par (100). This bond component will mature at par, which allows you to figure out your return on the investment.

The investment bank takes the money that you paid for the zero-coupon bond component and enters it into their books as capital, which they can then use for their needs (to satisfy Federal Reserve requirements, to lend, invest, or to trade).The difference between the zero-coupon bond and the principal invested is then used to buy options. Depending on the terms of the structured note, the bank may use a combination of out-of-the-money calls, puts, futures, or other types of options.

Factors that affect the terms quoted
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Interest rates

This is the most important factor, as it determines the cost of the zero-coupon bond, which then determines how much is left to buy options. The higher the interest rate, the more money is left over to buy options.

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Internal Funding Rate

In addition to market interest rates, credit spreads and the funding needs of the issuer impact pricing.

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Volatility

This is typically measured by the VIX (CBOE Volatility Index).

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Dividend

A structured note does not pay a dividend, but dividends may still affect their prices. Any dividend will be discounted from the option premium, which allows the option to become cheaper.

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Tenor

This is the length of the investment or the time to maturity.

Wrapping Up: Are Structured Notes the Right Investment for You?

At first glance, some may question the ability of structured notes to provide upside participation, capital preservation, and downside protection in the same investment. When you take a closer look and understand the mechanics of these investments, however, it becomes easier to understand what they are, how they work, and why investment banks sell these products.

Whether your portfolio and sophistication level are appropriate for investment in a structured note depends on many factors. At Paragon Capital Management, LLC we make the determination to invest in a structured note based on the individual investor's needs, market outlook, risk profile, and overall portfolio.

Structured notes can provide alternatives to a fixed-income strategy that wants more than can be found from standard investments through the bond market, but they are not for every investor. If you would like to know if structured notes would fit into your financial planning, investor profile, and overall portfolio strategy, contact our team here so that we can discuss the possibilities.

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Whether you feel as if you’ve outgrown your advisor or you just want a fresh perspective on portfolio strategies in our current market, our team of experts is here for you.

Howard Jacobson and Craig Novorr sitting at a desk in front of a monitor.