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Understanding Buffered Structured Notes - Capturing some upside without all the downside

Structured notes have been around for some time. Initially purchased by institutional investors to hedge stock market risk, structured notes have been available to retail investors for several years. There are many types of structured notes. One is a 'Buffer.'

A Buffer structured note is an investment that tracks the performance of a specific index - like the S&P 500 Index or the EAFE foreign stock index but caps your upside and downside. For example, the Buffer may absorb the first 10% of losses, while capping the upside to 20%. Downside and upside caps vary by issuer. The idea is to give you some participation in up markets but limit your downside. It is like the Goldilocks investment, not too cold, not too hot. However, there are some drawbacks to consider. First some background. 

What is a Buffered Structured Note? 

Structured notes are typically issued by large investment banks. Banks like HSBC, Barclays, JP Morgan, and other Wall Street Firms create the notes. The notes are issued on a specific day and mature at a specific date in the future. Maturity dates vary by issuer. Most mature in 1-3 years. The note tracks the performance of a stock index. This is known as the 'tracking index'. Some notes track a combination of indexes like capturing 20% of the Russell 2000, 50% of the S&P 500, and 30% of a foreign index. 

At maturity, the investor is paid in a lump-sum. The lump-sum value is calculated on a point-to-point. This means your starting value is subtracted from your maturity value and the Buffer downside or upside cap is applied. For instance, if you invest in a 10% Buffer and your $10,000 initial investment loses 10% on the maturity date, the issuer absorbs the full loss and you are paid back the $10,000. Beyond the Buffer, or the 10% loss, the investor is responsible. Say the tracking index loses 40%, the issuer absorbs 10% and you are responsible for the 30% loss. In this case, instead of losing $4,000 on your $10,000 investment, you are down $3,000. The Buffer saved you 10%. 

On the upside, the issuer can use leverage to magnify the performance. Some Buffers use leverage to enhance the performance. A Buffer structured note may credit two times the upside of the Russell 2000 index, up to a cap. For example, assume a $10,000 investment in a Buffer note that has a 25% upside cap and two times leverage on the upside. If the tracking index is up 13% by maturity, the crediting performance is two times that or 26%. However, the investor is capped at 25%. In this case, the investor's initial $10,000 is worth $12,500. Not too cold, not too hot. 

Example of a 20% Buffer Structured Note. Source: First Trust

Limitations and Risks

Capturing some upside but limiting the downside sounds like a win-win. But, there always is a 'But', there are a few caveats. Consider the following: 

1. There are no dividends or earnings along the way. Buffer notes do not credit dividends or interest. Dividends can make up a healthy part of the stock index. If the Buffer note tracks the S&P 500 index it will do so without the effect of dividends being reinvested. That is something to consider. For this reason, if you need dividends for income, structured notes are not the investment for you. For more on the importance of dividends, consider "The Critical Role of Dividends in Stocks' Long-term Total Return" by The Balance.com. 

2. The real risk is the solvency of the issuer. Remember when Lehman Brothers went bankrupt? What happened to the structured notes issued by Lehman? Poof. Gone. There is no guarantee the issuer will be there when the note matures, and the note is only as good as the issuer backing it. For this reason, consider a strong well capitalized issuer or you may want to buy notes from different issuers for diversification. 

3. Beware of the commission. In general, there is an upfront commission. However, there is also an "advisory share class", which I use, where the commission is waived, and the fee can be less. 

4. Lack of liquidity. Structured notes are meant to be held to maturity. If you need to cash in prior to maturity, the secondary market may be thin or non-existent. You never want to sell in a thin market. Make sure you have other sources of liquidity to wait out the duration of the note. 

Do Structured Notes Make Sense? 

Given all this, you may be wondering if Buffer notes make sense? There are pros and cons. Buffer notes do not provide 100% principal protection. In my opinion, Buffer notes provide a way for investors concerned about stock market volatility and are waiting on the sideline to tiptoe back into the market. These investors are looking for some upside without all the downside. An alternative is to dollar-cost average into a balanced portfolio of stocks and bonds. I am referring to traditional asset allocation. 

Keep in mind, it does not have to be an all or nothing decision. The structured notes I use have a minimum of $1,000 and in my opinion, for the right investor, can help round out a diversified portfolio. I like to sprinkle money around several notes with different issuers, different terms, and different maturities for added diversification. 

Barrier Notes

There are many other types of notes, like barrier notes. Barrier notes are the opposite of Buffer notes. An issuer of a Barrier note absorbs the losses after a certain percentage. For example, the investor is on the hook for the first 20% of losses in a Barrier note but the issuer absorbs any further losses. This is another way to limit your downside. 

Final Thoughts 

Structured notes like Buffer and Barrier notes are more complicated than traditional stocks and bonds, but there is a reason they have been embraced by large institutions for decades. If properly constructed with your goals and risk tolerance in mind, Buffer and Barrier notes can be a useful way for investors to get the Goldilocks of the investment world - some upside and some, but not all, of the downside. 

What do you think? Email me your thoughts:  

You may also like my other articles: 

Kiplinger Personal Finance: 5 Bear Market Lessons Learned from 20 Years as a Financial Advisor

Blog: Stock Market Insights - This is a Test in Staying the Course