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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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 andhow 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.

Understanding 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:

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.

The Advantages of Structured Notes

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:

1. 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.

2. 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.

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

4. 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).

5. 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).

The Risks of Structured Notes

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:

1. Credit risk: structured notes are typically senior unsecured debt obligations of the issuing financial institutions. The terms of the note will be paid at maturity if the issuing financial institution has not filed for bankruptcy. Investors should always consider the creditworthiness of the financial institutions that are issuing structured notes.

2. Market risk: structured notes have an issuance date and a maturity date. These are extremely important in determining the payoff at maturity. Because the structured note is based on the performance of an underlying asset, there is a market risk that the underlying asset will not move in a way that is beneficial to the note.

3. Income or lack of dividends: most structured notes are designed for growth, using a zero coupon bond that includes options or a derivative component to create the terms of the investment. For these growth notes, coupon payments are not issued during the interim quarters, but rather at maturity. Other fixed-income alternatives, however, like Yield Notes, can be designed for periodic coupon payments if the market is within certain parameters.

4. Liquidity risk: structured notes are designed to be held to maturity, and they do not have an active secondary market if the purchaser needs liquidity. While many issuers will buy their structured notes back if needed, it is not suggested that you sell them prior to maturity. If there is the potential that liquidity will be needed before the maturity date, it is not recommended that you invest in a structured note.

Strategies to Reduce Risk for a Structured Note

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:

  • 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.
  • 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.
  • 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.
Types of Structured Notes

Strategies to Reduce Risk for a Structured Note

The issue, sale, and calendar

The differences in structured notes are largely comprised of who they are purchased from and how they are configured. A retail structured note may be purchased from a commissioned investment advisor at a bank, online broker, commissioned broker, or directly from a wirehouse. When retail investors purchase a retail structured note, there are two main fees that they may be charged: the sales commission and the front-end load.

Institutional structured notes may be purchased through fee-based asset managers. These managers typically charge their fees based on Assets Under Management (AUM), regardless of which vehicle is used for those investing in structured notes. These managers may either buy the structured note from a retail calendar or have them custom-created.

Many of the structured notes in the above example are created by the investment banks and listed on a calendar at the beginning of the month. They allow distributors to sell the structured notes that have been listed on the calendar throughout the month.

Paragon Capital Management, LLC doesn't utilize the above methods for our clientele, as we use wholesale structured notes that are custom-built to suit the investment goals of our clients.

A custom-structured note is created on the day before or the same day that it is issued. This allows the issuing bank to have more certainty in the option or derivative component that they will need to purchase for their own counter party trading, which is why these custom-structured notes may often have better terms than those listed on the public calendar.

Custom-structured notes are typically only available to investors who have a $1 million minimum investment and are not generally open to retail investors.

The types of structured notes

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.

Buffer vs Barrier

The downside risk protection for a structured note can come through either a buffer or a barrier. A buffer protects a specific amount of principal invested from loss. A 20% buffer, for example, would protect against a 0-20% loss in the underlying asset class. Using this example, if the market was down 15% at maturity, the investor would receive their full principal invested back. If the underlying asset was down 25%, the investor would only lose 5% of their principal invested.

A barrier still protects a specific amount of principal, but the protection goes away if the market volatility passes through that barrier. In the same example above but with a 20% barrier, a 25% reduction in the value of the underlying asset would result in a total loss, but a 15% reduction would still lead to a full payout at maturity. A structured note with a barrier is riskier than one with a buffer.

Accelerated Buffer Note

An accelerated buffer structured note includes a downside buffer and upside participation. For example, an accelerated buffer note may be constructed to have a 20% buffer with a 160% upside over 6 years. If the market is down 0-20% at maturity, the investor will receive their principal back in full.

If the market is down more than the buffer, the investor will receive the difference. If the underlying reference asset is up, however, the investor will receive back 160% or a 1.6x return on their principal. For example, with a 10% rise in the underlying reference asset, the investor would receive back a 16% return on the principal.

Capped vs Uncapped

Some structured notes may have a capped upside participation. For example, a note may have upside participation but cap the upside at 24%. In this example, if the upside exceeds greater than a 24% return, you will not participate in the upside beyond 24%. There are uncapped notes that do not limit your potential upside participation, but they are rare.

Principal Protected Notes

Principal Protected Notes can have downside buffers of 100%, meaning that the principal invested is fully protected against any losses. Income from these notes is classified as ordinary income rather than capital gains, so they are typically suited for tax-deferred accounts.

Digital Coupon Note

Digital notes are for investors with a neutral to a moderately-bullish view of the markets or specific reference assets. They provide a one-time digital payoff structure if the asset is at or above a predetermined level when the note matures, in addition to a specific level of downside protection. For example, if an investor purchased a digital structured note that included a 30% digital coupon, a 20% buffer, and a 10% in-the-money provision, the investor would receive a 30% return on their principal if the underlying assets were anywhere between -20% and +30% at maturity.

What Affects the Terms & Pricing of a Structured Note?

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

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.

Credit spreads: the better the credit rating of the issuing bank, the better the terms that will be offered.

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

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.

Tenor: this is the length of the investment or the time to maturity. When the term is longer, the cost of the option typically increases, but the annualized cost decreases. When interest rates are low, the tenor tends to increase.


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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