- This article highlights the main differences between two financial instruments: structured notes and traditional bonds.
- The information contained in this article is useful for portfolio managers and investment advisors who are considering investing in either of these products as a strategy to optimize portfolio performance.
- FlexFunds offers an asset securitization program to repack structured notes that help optimize portfolios. For more information, please feel free to contact our experts.
In the world of finance, both structured notes and traditional bonds are popular investment instruments among asset managers looking to expand the distribution of their strategies or increase assets under management (AUM).
However, there are significant differences in terms of structure, risk, and return potential between these two instruments.
What are traditional bonds and structured notes?
Traditional bonds are classic debt instruments issued by governments, companies, or other issuing entities. When purchasing a bond, you are lending money to the issuer in exchange for a series of periodic interest payments and repayment of the principal at the bondâs maturity.
Bonds generally have a predictable payment structure and are considered relatively safe investments, particularly if issued by governments with strong credit ratings.
They tend to be a good option during times of equity market uncertainty and when interest rates are rising.
On the other hand, structured notes are complex financial products that combine different underlying asset classes. They can also be linked to a specific investment strategy.
Unlike bonds, structured notes do not guarantee a fixed, recurring series of interest payments; instead, their returns are usually linked to the performance of the underlying asset.
Portfolio managers may turn to structured notes as a way to diversify their portfolio and offer investors exposure to assets or strategies that might otherwise be difficult to access.
Therefore, these are hybrid investment instruments with a set maturity that combine characteristics of both fixed income and equities. This allows for returns in more volatile markets without sacrificing the stability offered by fixed income.
Main differences between structured notes and bonds
Bonds and structured notes are financial instruments with significant differences in terms of their structure, features, and risks.
1. Issuer
Structured notes can be issued by various financial entities and are linked to multiple classes of underlying assets. In contrast, bonds are issued by government institutions, companies, and others seeking financing through debt issuance.
2. Returns and payment flows
Bonds offer periodic interest payments, generally semi-annually or annually, and return the invested principal at maturity.
These payments tend to be recurring, fixed, and predictable, providing income stability. However, yields are usually more modest compared to other investment instruments.
Structured notes may involve a series of variable payments that could combine interest, derivatives, and other structured elements.
Therefore, returns can be linked to the performance of a stock index, a basket of assets, or a specific investment strategy, among others. This means payment flows depend on the underlying assetâs performance, so returns are not predictable.
3. Risk
Traditional bonds are generally considered safer investments compared to structured notes.
Bonds issued by solid governments or companies with high credit ratings carry less default risk. However, all bonds are subject to interest rate and market risks.
In comparison, structured notes can involve a variety of risks. Depending on their design, they may include market risk, credit risk, liquidity risk, and risks related to the underlying asset.
If properly managed within an investment portfolio, they allow the portfolio manager to offer clients an opportunity to diversify their investments.
4. Maturity
Bonds have fixed terms that usually range from short to long term; in some cases, perpetual bonds with no defined maturity exist. Generally, bonds mature between 5 and 30 years.
In the case of structured notes, terms can vary greatly and are often linked to the useful life of the underlying assets.
5. Liquidity
Bonds are typically long-term investments but enjoy high liquidity since they are easily tradable in secondary markets, although losses can occur depending on interest rate movements and market conditions.
Conversely, structured notes often have specific maturity terms, which reduces their liquidity because trading can be more complex given the absence of a secondary market.
However, asset managers can take advantage of the diversification and customization opportunities offered by structured notes to manage risk in highly uncertain markets.
6. Credit rating
Credit ratings for bonds are usually assigned by specialized agencies, while for structured notes, ratings depend on the structure and the underlying assets that compose them.
7. Transparency
The structure and terms of bonds are quite transparent and easy to understand. Although structured notes are complex financial instruments, they provide transparency by clearly disclosing the underlying assets shaping the note and the investment strategy objective at the time of issuance.
8. Inflation protection
Some bonds are linked to inflation, providing some protection against the erosion of the investorâs purchasing power.
However, asset managers may prefer structured notes when these are composed of underlying assets that can serve as an inflation hedge, such as real estate, which is a good alternative to protect clients against rising inflation.
In summary:
| Criterion | Traditional bonds | Structured notes |
|---|---|---|
| Issuer | Governments, companies, and institutions seeking debt financing | Financial entities creating specific products linked to certain underlying assets |
| Payment flows | Fixed and periodic, both interest and principal | Vary according to the structure and underlying assets |
| Risk | Lower risk; depends on issuer; affected by interest rates and market | Higher risk; includes market, credit, liquidity, and underlying asset risks |
| Maturity | Fixed terms between 5 and 30 years; perpetual bonds exist | Variable terms; linked to the useful life of the underlying asset |
| Liquidity | Usually high, tradable in secondary markets | Low or very limited; improved by securitization process |
| Credit rating | Assigned by specialized agencies | Depends on the specific structure and risk of underlying assets |
| Transparency | High; simple and easy-to-understand structure | Conditional transparency; complex structure, but detailed at issuance |
| Inflation protection | Some provide inflation coverage through variable interest rates | May contain underlying assets that protect against inflation directly or indirectly |
When to choose structured notes or traditional bonds?
It is important for portfolio managers to understand these differences before selecting between a bond or a structured note.
Each financial instrument has its own characteristics and risk levels. The choice should be based on the objectives of the investment strategy, risk tolerance, and time horizon that could benefit their clients.
Conventional bonds are preferred for strategies focused on capital preservation, generating periodic income streams, and stability. They are also chosen to comply with standard regulatory requirements.
They are ideal to complement a portfolio already holding equity assets given their low volatility.
In comparison, structured notes are used by asset managers to achieve greater diversification and versatility, and to gain exposure to more sophisticated strategies with higher return potential.
They are typically included in institutional strategies or funds seeking returns above the market average.
That is:
| – | Traditional bonds | Structured notes |
|---|---|---|
| Profile | Managers seeking stability and simplicity in investment portfolios | Managers wanting to develop sophisticated, comprehensive strategies to meet objectives |
Evolution and decision-making
Both financial instruments can evolve over time in terms of returns, risk, and structure. For example, a bond can be convertible into shares, and a note, being linked to assets and derivatives that can change value, may modify its payments and investment performance.
The risk of a bond depends on the issuerâs credit quality, which can vary over time, as can its price if interest rates rise after purchase. For structured notes, risk can vary significantly according to the structure, volatility, and illiquidity of the underlying assets.
Similarly, bond returns tend to be predictable and stable if held to maturity, although some bonds have variable rates that can adjust returns based on reference rate changes.
In structured notes, returns are subject to the performance of the underlying assets and are therefore usually unpredictable.
In many cases, asset managers choose a combination of both instruments to diversify their portfolio and balance risks and returns.
FlexFunds, a leading company in the design and launch of investment vehicles, offers asset managers the opportunity to securitize investment strategies that include underlying assets in the form of structured notes or portfolios of bonds and other fixed-income instruments.
Having a fast and cost-efficient ETP can help increase your AUM by facilitating access to international investors.To learn more about FlexFundsâ ETPs and our asset securitization program, please contact our team of specialists. We will be happy to assist you!
