1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 12
Structured Notes
August 2012

2. Chapter summary and outline
This chapter outlines the features of structured notes, what types
of investors would invest in structured notes, governance,
documentation, risks and common examples of structured notes.
Chapter outline:
• What is a structured note?
• Issuer
• Wrapper
• What type of investors would invest in structured notes
• Documentation required for structured notes
• Examples of structured notes
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3. What is a structured note
• Is a debt instrument:
– Structured to link possible coupon payments, OR
– Market value of the notes is referenced to the performance of other underlying
financial instruments
• Underlying instruments:
– Interest rate
– Equities
– Indices
– Credit markets
– A basket of these instruments
• Contain one or more embedded options or employ other derivatives
strategies
• Holder of the structured note does not typically have claim over the
underlying instruments
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4. What is a structured note - 2
• Principal component:
– Without collateral – depend on note issuer for repayment of principal
– With collateral - form of zero coupon or corporate bonds or other types of
securities
• Returns component:
– Derivative component provides exposure to chosen asset class,
– Selling an option in exchange for a fixed premium or,
– Taking a long position in the option
• Structure potentially links the coupon payments and/or principal
repayment to the performance of the underlying instrument
• Issuer enters into derivative contract or swap transaction with another
institution
• Investors should review the product offering documents to ensure that
they fully understand the information in the documents before making
any investment decisions.
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5. Issuer
• Direct Issuance (on Balance Sheet)
– Bank issues the notes to the note holders
– Note holders bear the credit risk of issuer
– The issuer can apply the proceeds according to its treasury or funding
requirements
• SPV Issuance (off Balance Sheet)
– The SPV issues the notes to the note holders
– The SPV will in turn use the proceeds to acquire collateral for the notes
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6. Wrapper
• Legal form in which a structured product is offered to the end investor
Debentures
• Senior, unsecured and unsubordinated debts
• Securities and Futures Act (“SFA”)
• Subject to prospectus requirements
– Rights and liabilities attaching to the securities
– Assets and liabilities, profits and losses, financial position, performance and
prospects of the issuer
– Assets and liabilities, profits and losses, financial position, performance and
prospects of the underlying entity, if that underlying entity is controlled by the
person making the offer or parties related to it
• Exempted from the prospectus requirements
– Made only to institutional investors, accredited investors or for a minimum
consideration
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7. Wrapper - 2
Structured Deposits
• Structured deposits also embed a derivative component
• Structured deposits are a type of deposit and are not debentures
• Only be issued by banks:
– Financial Advisers Act (“FAA”) Guidelines on structured deposits need to be
observed except:
– Accredited investors
– High net worth individuals
– Overseas investors who are not Singaporeans or Singapore permanent residents
– Institutional investors
• FAA – purpose is to set out standards of conduct expected of licensed and
exempt financial advisers and their representatives when advising on
structured deposits
– Advocate fair and adequate product information disclosure
– Require the financial advisors to be properly trained and competent in
recommending the product.
– Screen investors to assess their suitability and have reasonable basis for the
recommendation of the product.
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8. Type of investors in structured notes
• Structured notes provide: yield enhancement and market access;
• For investors with greater risk appetite - higher risk & higher potential yields,
• Important to understand the underlying investment strategies
Assessing Product Suitability for Retail Investors
• Financial institutions need to be clear about investors’ objectives and make
full disclosure of the potential risks
• Retail investors require some degree of principal guarantee
– must explain the risk of principal loss or unlimited downside and ensure that the
retail investors fully understand the risks
• If product does not suit the retail investors’ wealth and risk tolerance, need
to advise investors of this fact
• Investors insist on proceeding with their transaction on this product
– the financial institution that is selling the structured notes must have the
necessary documentation and have the investors’ acknowledgement on it.
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9. Factors for Investors’ Consideration
• Understand that potential for higher payoffs comes with assuming more risk
• Liquidity:
– Not be fully redeemable during the tenure of the structured product
– Early withdrawal may result in loss of part or all of the principal
• Risks - Higher risks due to the different layers involved
• Returns:
– Tied to various underlying instruments
– Returns will vary based on the performance of the underlying instruments
– Possibilities that the instruments’ principal values will be affected
• Terms and Conditions:
– Review the terms and conditions
– Explains obligations, and risks involved
• Fees and Charges:
– Well informed of the fees and charges
– Management fee is likely to be higher than standardised financial instruments
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10. Documentation Required for Structured Notes
• Prospectus
• Product Highlights Sheet
– Highlights the key terms and a risk of the product using simple and concise
language
– Complements the prospectus
• For Institutional Investors or Accredited Investors
– Exempted from providing the Prospectus or Product Highlights Sheet
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11. Contents of the Prospectus
• Information that investors and representatives who are providing financial
advisory services would reasonably require to make an informed
assessment of the securities
– The rights and liabilities attaching to the securities
– The assets and liabilities, profits and losses, financial position and performance,
and prospects of the issuer
– If the underlying entity is controlled by the person and/or its related parties
making the offer, the assets and liabilities, profits and losses, financial position
and performance, and prospects of that entity
– In the case of an offer of units of shares or debentures, where the person making
the offer, or an entity which is controlled by the person and/or its related parties,
the offer or is or will be required to issue or deliver the relevant securities, or to
meet financial or contractual obligations to the holders of those units, the
capacity of that person or entity to issue or deliver the relevant securities, or the
ability of that person or entity to meet those financial or contractual obligations.
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12. Contents of the Product Highlights Sheet
• Key features and risks of the investment product
• Format as set out in Guidelines on the Product Highlights Sheet prescribed
in the SFA, not contain any information that is not included in the
Prospectus and not contain any information that is false or misleading
• Issuers should avoid using technical terms and refrain from using
disclaimers in the Product Highlights Sheet
– Where technical terms are unavoidable, issuers should attach a glossary to
explain these technical terms.
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13. Contents of the Product Highlights Sheet - 2
• Should contain the following:
– Product name and summary information
– Product suitability
– Key product features
– Parties involved
– Possible outcomes of the investment
– Key risks
– Fees and charges
– Frequency of valuations, how to exit from the investment and the risks and costs
in doing so
– Contact information
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14. Examples of Structured Notes
Yield enhancement structure – Range Accrual Note (RAN)
• Fixed income product
– Where coupon is linked to the performance of a reference interest rate index,
such as the London Interbank Offer Rate (“LIBOR”)
– Enhanced interest is accrued each day that the reference index fixes (usually
based on the closing price) within a predetermined range, while a lower coupon
or zero interest is accrued any day that the reference index fixes outside of the
range
• Provides relatively high return if reference index fixes within the certain
range
• Made up of fixed-rate bond combined with:
– strip of digital caps and floors of different strike prices,
– the cap having the higher strike and the floor lower
• Return from the note could be higher than traditional fixed rate securities of
comparable maturity and credit quality
• If the reference index does not stay within the predetermined range, the
return may be lower than the return on comparable traditional fixed rate
securities.
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15. Examples of Structured Notes - 2
Yield enhancement structure – Range Accrual Note (RAN) (cont)
• Provides full principal preservation while some RANs provide minimum
return of initial investment if held to maturity or call
• Some RANs issued with Call provision:
– Issuer (but not the investor) has right to call the note, before the scheduled
maturity date, typically at par,
– A call feature creates uncertainty for the investor as to whether the RAN will
remain outstanding until its maturity date => Callable RANs often carry higher
yields than non-callable RANs,
• Most callable RANs offer some Call protection for example: not callable for
the first 2 years
• Motivations
– The potential to obtain returns above the market by taking a view on future
interest rate levels;
– Possible principal preservation or minimum return of initial investment upon
maturity or call;
– Diversification of the existing fixed income portfolio.
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16. Examples of Structured Notes - 3
Yield Enhancement Structures – Inverse Floater Note
• Structured note that pays coupons that are inversely linked to a floating
interest rate index;
• Initial coupon is much higher than a bank deposit rate
• It is extremely sensitive to an increase in interest rates and will expose the
holder of the note to unlimited downside risk,
• The note can be structured such that the principal is not affected and the
coupon is subject to a floor and expressed as follows:
Max [X% - Leverage * Floating Rate Index, Min Coupon]
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17. Examples of Structured Notes - 4
Yield Enhancement Structures – Variable Maturity Multi Callable Range Accrual
Note
• A RAN embedded with callable feature at each interest fixing date
• Higher yield as the investor will be selling a Bermudan Swaption on top of
buying a RAN,
• Issuer has right to terminate the structure on various rate fixing dates
• Bermudan Swaption:
– Interest rate option where the seller has the obligation to enter into an underlying
swap at various exercise dates during the life of the swaption
– can be exercised only at the rate fixing dates
• American Swaption:
– can be exercised at any point during the life of the swaption
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18. Examples of Structured Notes - 5
Structured Notes with some degree of principal preservation – Embedded Zero
Coupon
• Combines a zero coupon bond with an option whose payoff is linked to an
underlying asset or benchmark
• Appealing under low interest rate environments as it offers greater return
than money market instruments
• Majority of proceeds invested in zero-coupon bonds whose maturity date
and principal amount matches that of the notes
• Balance of proceeds – invested in derivatives like call option
• Investing in zero coupon bond - preserves the principal amount at maturity
of the product,
– But investor is exposed to the credit risk of the issuer
– E.g. 100% principal preservation note may only be guaranteed by the issuer up
to a certain percentage
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19. Examples of Structured Notes - 6
Structured notes with some degree of principal protection – Constant
Proportion Portfolio Insurance (CPPI)
• Investments dynamically allocated between risk-free and risky assets
• Protects the capital initially invested but allows participation in the upside of
the risky asset should the market move upward
• Manager needs to dynamically rebalance between the risk-free assets and
the risky assets depending on the performance of the market
– If market was to go up, more capital will be allocated to the risky assets
– If market was to go down, risky assets will be unwound and more capital
allocated to the risk-free assets
• Allows increased participation in the rising market and limiting the losses in
the falling market.
Example:
• Initial amount of the portfolio (I) = SGD 100,000
• Absolute Floor (F) = SGD 90,000 (ie the point where investors will be fully
invested in risk free assets)
• Reserve (or cushion) = I – F = SGD 10,000
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20. Examples of Structured Notes - 7
Structured notes with some degree of principal protection – CPPI (cont)
• Multiplier (M) is a factor based on investors’ risk profile and is typically
derived from the maximum 1-day loss of risky assets
• Assuming a maximum 1-day loss of 25%, the multiplier M will be 4 (1/0.25).
• Amount invested in risky asset = M x (I – F) = 4 x (SGD 100,000 – SGD
90,000) = SGD 40,000
• The remaining amount in the portfolio will be invested in risk-free assets or
held in cash:
– The portfolio will be rebalanced periodically as determined by the investors.
– The amount I should be adjusted with any gains or losses
• Ideally, the portfolio should grow, hence the amount to be invested in risky
assets would increase
– E.g. if the portfolio becomes SGD 110,000, the amount available for investment
in risky assets becomes SGD 80,000
– However, if the portfolio reduces, investors may need to sell the risky assets to
keep to the targeted asset allocation
– E.g. if the portfolio becomes SGD 95,000, the amount available for investment in
risky assets becomes SGD 20,000
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21. Examples of Structured Notes - 8
Structured notes with some degree of principal protection – CPPI (cont)
• Downside risk of CPPI:
– If rebalancing is not done frequently, there is a possibility that the value of the portfolio
reduces to less than the level allowed by the investors when there is a drastic and
sudden decrease in the value of risky assets
Structured notes with some degree of principal protection – Dynamic Proportion
Portfolio Insurance (DPPI)
• Similar to CPPI, except where the multiplier M is a constant in CPPI, the
multiplier M in DPI is variable
• Example of DPPI:
– Amount invested in the risky assets is allowed to fluctuate within a band of 3-5
times of the buffer with the initial amount invested in the risky assets set at 4
times the buffer:
– Portfolio is rebalanced when the amount invested in risky assets falls outside the
band and the adjustment is made to move the risky assets multiple back to the
starting point of 4 times
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22. Examples of Structured Notes - 9
Market access – Exchange-Traded Notes (ETNs)
• No fixed periodic coupon payments and the principal is at risk
• Structured notes that are listed and traded on exchange
• Key difference between ETN and unlisted structured notes => tradability
– Provides greater liquidity for investors
– Although both have same risk related to the credit quality of the issuer
• Price of the ETN = function of the credit quality of the issuer and the
performance of the underlying market benchmark or strategy
– ETF investors hold a proportional stake in the financial product(s) that the ETF is
tracking or following
• Absence of tracking error in ETNs after adjustments for fees
– ETP performance based on the portfolio of instruments (normally sample-based)
put together to track an underlying market and valued on a net asset value basis
– Synthetic ETFs which provide exposure to the underlying market through swap
transactions typically also have little or no tracking error, after adjusting for fees
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23. Examples of Structured Notes - 10
Market access – Exchange-Traded Notes (ETNs)
• Different tax treatment between ETNs / ETFs:
– ETNs - tax can be deferred until the product is sold
– ETFs - due to the yearly capital and income distributions, these may be taxable
events for investors
Market access – Index-Linked Notes
• In exchange of slightly less upside potential, Index Linked Notes may
incorporate a minimum return at maturity in additional to the original
principal
• Can be structured with either an average periodic return and specified
participation rate or periodic cap.
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24. Examples of Structured Notes - 11
Market access – Participatory Notes (PNs)
• PNs are offshore derivative instruments,
• Not registered with the securities regulator of its underlying assets
jurisdiction, and not listed
• Example: PNs are issued by Indian-based securities firms to foreign
investors;
• Underlying assets are stocks and any dividends or capital gains would flow
through to the holders of PNs
Market access – Access Notes
• Unlisted corporate fixed income securities
• Offered on original issue bases directly to investors or through a financial
intermediary.
• Well recognised companies with large existing investor base for their listed
securities may use this type of securities to raise funds.
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25. After Sales for Structured Notes
• Structured note must be marked-to-market (MTM) periodically so that note
holder is aware of the market value
• Structured notes are a composite of various flow products
– There are ready MTM prices for these flow products that make up the structure
– MTM of structured notes are a combination of the respective MTM of its
component flow products
• MTM value must be obtained from an independent source and not from the
internal traders who trade these flow products
• MTM statements must be sent to the note holder or disclosed on the
website of the issuer or distributor by a unit which is independent of traders
who trade the products
• Issuers of unlisted debentures
– To ensure investors provided with timely and meaningful ongoing disclosures
– To provide investors with semi-annual reports to update them on their
investments, and
– Immediately disclose any changes which may materially affect the risks and
returns, or the price or value of the structured notes to investors
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