Structured Note

A structured note is a financial product that combines traditional debt securities with derivative instruments to offer customized investment opportunities. It typically consists of a bond component, which provides fixed income, and a derivative component, which ties the return to an underlying asset, such as stocks, commodities, or interest rates. Structured notes are designed to meet specific investment goals, such as capital protection, enhanced returns, or exposure to certain market conditions. They are often used by institutional investors and high-net-worth individuals but can carry higher complexity and risk due to the derivatives involved.

A structured note is a financial product that combines features of traditional debt securities, such as bonds, with derivative components. These derivatives are linked to the performance of underlying assets, such as equities, commodities, interest rates, or currencies. The primary appeal of structured notes lies in their customization, offering investors tailored risk-return profiles, including capital protection, enhanced returns, or exposure to specific markets.

In the Indian context, structured notes are typically available in rupees, and the investment process follows similar principles, but with the return and principal protection being linked to underlying assets, which might be tied to Indian or international markets.

Key Components of Structured Notes in Rupees

1. Debt (Bond) Component:

• Principal Guarantee: In some structured notes, the bond component guarantees the return of the principal investment in rupees, provided the note is held until maturity.
• Interest Payments: These structured notes may also offer fixed or floating interest rates, either paid periodically or at maturity, depending on the terms of the product.

2. Derivative Component:

• The derivative component links the return to the performance of an underlying asset (e.g., an equity index like the Nifty 50, a commodity like gold, or a currency exchange rate). The returns generated from this component will be denominated in rupees, and can either be positive (if the underlying asset appreciates) or negative (if the underlying asset falls).
• For instance, a structured note could be tied to the performance of the BSE Sensex or the Nifty 50 index, meaning that the return at maturity will depend on the change in the index’s value.

How Structured Notes Work in the Indian Market

1. Issuance:

• In India, structured notes are issued by banks, financial institutions, or investment firms. They can be issued in rupees and typically have maturity periods ranging from 1 to 5 years. The terms of the note will outline the return mechanism, including principal protection, participation rate in the underlying asset’s return, and other terms.
• The investor will purchase the note, typically in denominations such as ₹1,000, ₹10,000, ₹50,000, etc.

2. Investment and Return Generation:

• Capital Protection: Structured notes in India are often marketed with a capital-protection feature. This means that if the investor holds the note until maturity, they are guaranteed to receive at least the principal amount in rupees (₹1,000 or ₹10,000, for example).
• Performance of the Underlying Asset: The return is based on the performance of an underlying asset. For example, if the note is linked to the performance of an equity index (like the Nifty 50), the return on the note could be a fixed percentage of the index’s growth over the holding period. If the underlying asset performs poorly, the investor may only receive the principal amount (in rupees) or a reduced return.

3. Example of a Structured Note in Rupees:

• An investor in India buys a structured note linked to the Nifty 50 index. The note has a 5-year maturity and a 10% principal protection feature. At the end of 5 years, if the Nifty 50 index has appreciated by 25%, the investor may receive 75% of the index’s gain (after deducting any fees or cap), along with their original principal in rupees. Conversely, if the index drops by 10%, the investor will only receive their ₹10,000 principal back (if principal protection is provided).

4. Callable or Auto callable Features:

• Some structured notes in India come with callable or auto callable features, which allow the issuer to redeem the note early if certain conditions are met (e.g., if the underlying asset appreciates beyond a specific threshold). This could limit the investor’s potential upside since the note might be called before it reaches full maturity.

Types of Structured Notes in India

1. Principal-Protected Structured Notes:

• These notes guarantee the return of the principal investment (in rupees) at maturity, provided the investor holds the note until the end. These are typically linked to equity indices or other financial assets.
• Example: A structured note linked to the Sensex offers a 100% principal protection. The investor receives their principal amount (in rupees) back at maturity, plus a fixed percentage of the index’s return, subject to caps or other conditions.

2. Non-Principal-Protected Structured Notes:

• These notes do not guarantee the return of the principal and expose the investor to potential losses. The return is highly dependent on the performance of the underlying asset.
• Example: A note linked to the performance of gold prices over a year, with no protection on the principal amount.

3. Interest-Rate Linked Structured Notes:

• These notes are linked to interest rates, either domestic (e.g., RBI rates) or international (e.g., LIBOR or SOFR). These are often used by investors seeking exposure to changes in interest rates in the Indian economy.
• Example: A structured note could offer returns tied to changes in Indian government bond yields or the repo rate.

4. Currency-Linked Structured Notes:

• These notes are linked to the performance of foreign currencies against the rupee. They are used by investors who want exposure to currency movements.

Advantages of Structured Notes in Rupees

1. Customization: Structured notes can be tailored to suit the investor’s specific goals, risk tolerance, and market outlook. In India, this flexibility can allow exposure to a broad range of asset classes, including equities, commodities, currencies, or interest rates.
2. Capital Protection: Principal-protected structured notes are attractive to conservative investors in India, as they offer some level of capital safety, even in volatile markets.
3. Potential for Higher Returns: Structured notes may offer higher returns than traditional fixed-income products, as the derivative component can provide leveraged exposure to market movements.
4. Diversification: Investors can diversify their portfolios by gaining exposure to asset classes and markets (such as commodities or global equities) that may not be directly accessible.

Risks of Structured Notes in Rupees

1. Issuer Credit Risk: Investors are exposed to the credit risk of the issuing institution. If the issuing bank or financial institution defaults, the investor may lose their principal and any expected returns, even if the underlying asset performs well.
2. Liquidity Risk: Structured notes are often illiquid. They cannot be easily traded or sold in secondary markets, making them less suitable for investors who may need immediate access to funds.
3. Complexity: Structured notes can be difficult to understand due to their complex features and the interplay of the bond and derivative components. Investors in India need to be aware of the terms and conditions, including the risks associated with derivatives.
4. Cap on Returns: Some structured notes limit the return on the investment (e.g., a maximum percentage gain on the underlying asset), which could mean missing out on substantial upside potential.
5. Market Risk: The performance of the underlying asset can be highly volatile. If the asset linked to the note underperforms, the investor may receive little or no return on their investment, particularly in non-principal-protected notes.

Conclusion

Structured notes in India, like in other global markets, offer a unique blend of debt and derivative features, allowing investors to tailor their investment strategies to specific market views, risk profiles, and return objectives. However, they come with significant complexities and risks that investors must carefully consider. Structured notes in rupees provide opportunities for enhanced returns, capital protection, or exposure to diverse markets, but they are not suitable for all investors. A clear understanding of the product’s structure, underlying asset, and potential risks is essential before investing in structured notes.