- This article highlights the main differences between two financial instruments: structured notes and traditional bonds.
- The information contained in this article is valuable for portfolio managers or investment advisors who are looking to optimize the performance of an investment portfolio.
- Thanks to the features of structured notes, FlexFunds can offer innovative and customized solutions that can help increase your AUM. If you want to delve deeper into the investment vehicles developed by FlexFunds and find the solution that best suits your needs, do not hesitate to contact our team of specialists.
In the world of finance, both structured notes and traditional bonds are popular investment vehicles among asset managers looking to expand the distribution of their strategies or increase their AUM. However, there are significant differences in structure, risk, and potential performance between these two instruments. Below, we will highlight the main differences between structured notes and traditional bonds, which will allow any portfolio manager to understand which might be the best option based on the needs and goals of their clients.
What are traditional bonds and structured notes?
Traditional bonds are classic debt instruments issued by governments, companies, or other entities. When you purchase a bond, you are lending money to the issuer in exchange for a series of periodic interest payments and the return of the invested capital at the bond’s maturity. Bonds usually have a predictable payment structure and are considered a relatively safe investment, especially if they are issued by governments with strong credit ratings. They are often a good choice during times of equity market uncertainty and rising interest rates.
Structured notes are complex financial products that combine different underlying asset classes and may be linked to a specific investment strategy. Unlike bonds, structured notes do not guarantee a series of fixed and recurring interest payments. Instead, their returns are typically tied to the performance of the underlying asset. Portfolio managers can turn to structured notes as a way to diversify their portfolios and offer investors exposure to assets or strategies that might otherwise be difficult to access. Therefore, these are hybrid investment instruments with a specific maturity period that combine the features of fixed and variable income, seeking the best of both worlds.
Main differences
Bonds and structured notes are financial instruments that have significant differences in terms of their structure, characteristics, and risks. Below are the 8 key differences between the two types.
1. Issuer
Structured notes can be issued by various financial entities and are linked to multiple underlying asset classes, while bonds are issued by governmental institutions, corporations, and others seeking financing through debt issuance.
2. Yield and payment flows
Bonds offer periodic interest payments, usually semi-annually or annually, and return the invested capital at maturity. These payments are often recurring, fixed, and predictable, providing income stability, although the yield is typically more modest than 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 that payment flows will depend on the performance of the underlying asset, making the yield unpredictable.
3. Risk
Traditional bonds are generally considered safer investments compared to structured notes. Bonds issued by solid governments or companies with high credit ratings have a lower default risk. However, all bonds are subject to interest rate and market risks.
Structured notes can involve a variety of risks, depending on their design, including market, credit, liquidity, and risks related to the underlying asset. Properly managed within an investment portfolio, these risks can allow portfolio managers to offer their clients opportunities for diversification. It is essential to fully understand the different risks before investing in structured notes.
4. Maturity
Bonds have fixed terms that typically range from short to long-term, and in some cases, there are perpetual bonds with no defined term. In general, bond maturities are between 5 and 30 years.
In the case of structured notes, maturities can vary widely and are often linked to the lifespan of the underlying assets.
5. Liquidity
Bonds are often long-term investments but enjoy high liquidity as they are easily tradable in secondary markets, although losses can be incurred depending on changes in interest rates and market conditions.
Structured notes often have specific maturity periods, which can reduce their liquidity due to 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 a highly uncertain market.
6. Credit rating
Bonds’ credit ratings are typically provided by specialized agencies, while the credit rating of notes depends on their structure and the underlying assets.
7. Transparency
The structure and terms of bonds are relatively transparent and easy to understand. Structured notes, despite being complex financial instruments, offer transparency since the underlying assets that shape them, and the goal of the investment strategy are exposed during their creation.
8. Inflation protection
Some bonds may be linked to inflation, providing some protection against the erosion of the investor’s purchasing power. However, asset managers may opt for structured notes when they are composed of underlying assets that can serve as a hedge, such as real estate, making them a good alternative to protect their clients from rising inflation.
Evolvement and decision-making
It is important for portfolio managers to understand these differences before selecting between a bond or a structured note. Each financial instrument has its unique characteristics and risk levels. The choice between these instruments should be based on the objectives of your investment strategy, risk tolerance, and time horizon, which could benefit your clients.
Both financial instruments can evolve over time in terms of performance, risk, and structure. For example, a bond can be convertible into stocks, and a note, when linked to assets and derivatives, can change in value, altering its payments and investment performance. The risk of a bond depends on the credit quality of the issuer, which can vary over time, just as the price can fluctuate if interest rates rise after the purchase. In the case of structured notes, the risk can vary significantly depending on the structure, volatility, and illiquidity of their underlying assets.
Similarly, the yield of a bond is usually predictable and stable if held until maturity, but there are bonds with variable rates that can offer adjustments in yield due to changes in benchmark rates. In the case of structured notes, the yield is subject to the performance of the underlying assets that compose them and is, therefore, typically unpredictable.
In many cases, asset managers opt for a combination of both instruments to diversify their portfolio and balance risks and returns.
FlexFunds, a leading company in setting up and launching investment vehicles, offers asset managers the opportunity to securitize investment strategies in the form of structured notes or repackage bond portfolios and other fixed income instruments. Having an agile and cost-effective ETP can help increase your AUM and facilitate access to international investors. If you have any doubts or would like to delve further into this, you can contact one of our experts to submit your inquiry.
