Markets Insight
  •  1/27/2022

Structured Investments in Action Part I: Understanding Downside Protection

By SIMON

This spotlight is intended as a broad overview to understanding the main types of principal protection offered by structured investments and what each one means in terms of risk.

Investors often look to the world of structured investments for ways to gain exposure to the markets while simultaneously maintaining a level of protection against market declines.  Structured investments with full or partial principal protection  can offer a risk-managed approach within your portfolio, providing peace of mind that you should receive some or all of your principal at maturity regardless of the market’s performance. However, you must hold the structured investment until maturity in order to receive the stated protection, and any promise of protection will always be subject to the issuer’s creditworthiness and will depend on the specific terms of the offering.

What is a principal protected structured investment?
A structured investment with downside protection generally refers to an investment that combines a zero-coupon bond with a derivative component, where the payout is linked to an underlying asset or index (an “underlier”). Not surprisingly, the more risk you are willing to take on, the higher your upside potential will be and vice versa. Investments with full principal protection can be issued both in note form (as senior unsecured debt obligations of the issuing bank), as well as in certificate of deposit form (backed by FDIC insurance, up to statutory limits). Investments with partial principal protection are issued in note form, and not available as certificates of deposit.

Mechanics matter!
Downside protection comes in many different forms, from 100% principal protection to protection that can actually “disappear” if the investment’s underlier breaches a certain specified level.  This variety across the risk-return spectrum is an appealing trait that the structured investment market is known for, offering a range of strategies for investors with varying risk appetites.

Because all downside protection is not created equal, when analyzing an investment, it’s critical to understand just how much protection you have on the downside and what conditions must be met, if any, to achieve this protection. Mechanics matter!

Below are some of the common types of downside protection found in the structured investment market today, and how they compare.

Reminder: Because any form of principal protection on a structured investment is always subject to the credit risk of the issuer, you must be comfortable with the creditworthiness of the issuer.  You must also be comfortable with holding the note until maturity in order to receive the offering’s stated terms.

  • Full issuer protection: Your principal investment will be returned at maturity.
  • Hard buffer: A type of protection that absorbs a fixed percentage of the underlier's loss. Beyond the hard buffer, you face losses that are one-to-one with the underlier.
  • Barrier: A type of protection that absorbs a fixed percentage of the underlier's decline; however, if the underlier declines beyond a specified level, this protection disappears, and losses are one-for-one from the underlier’s initial level on the trade date. This type of protection may be observed continuously, daily, or at maturity.

The visuals included above are hypothetical examples, do not reflect any specific structured investment, and are solely intended to help you understand how different protection methods work.

Ready to compare?
Let’s look more closely at three hypothetical notes to underscore how these types of protection play out in negative market scenarios.

Putting it All Together
Peace of mind with full principal protection

The table above highlights an attractive feature of structured notes with full principal protection: peace of mind that regardless of the performance of the underlier, you will receive 100% of your initial investment back if you hold until maturity, subject to the credit risk of the issuer.  However, although they offer full principal protection, the return for a market linked note is dependent on the performance of the underlier, meaning your return may be less than a typical fixed interest rate bond, or even zero, at maturity. One well-known trait of market linked CDs is that they offer not only full principal protection at maturity but also FDIC insurance, subject to statutory limits.

A degree of dependable protection with hard buffers
As shown in the table above, hard buffers are considered more protective (i.e., less risky) than barriers since they provide protection, regardless of the performance of the underlier.  Even if the underlier declines to zero, you will receive the stated buffer protection amount (e.g., 20% in the table above), subject to the credit risk of the issuer, as always.  Hard Buffers can be a way to add a degree of risk management to an equity allocation, with the understanding that they generally come with a limit on upside participation in the underlier (either through a stated maximum return or a participation rate).

Conditional protection and greater upside with barriers
It is important to understand two key aspects about barriers. First, and most importantly, barrier protection is conditional.  It is conditional upon the underlier trading at or above a specified level (either at maturity, on a daily basis, or continuously, depending on the type of barrier).  If this condition is not met—that is, if the underlier drops below the barrier level—you no longer have downside protection, but rather one with full exposure to the underlier’s decline.  Given the additional risk, notes with a barrier can offer more upside opportunities, so long as you are comfortable with the potential for exposure to the full downside risk of the underlier if the barrier is breached.

Second, barriers can be observed at different times such as:

  • barrier that is observed at maturity,
  • barrier that is observed throughout the term of the product on a daily basis at market close, or
  • barrier that is observed during the term of the product continuously, throughout each trading day.

Make sure you know which barrier observation type applies to an investment, and keep in mind that a continuously observed barrier usually allows for somewhat more upside versus the other two types, all else held equal, since there is greater risk of barrier breach.

A note on taxes
It is important to note that the tax treatment on structured investments can vary based on a variety of factors and may also be subject to change. Always review the tax section of an investment’s offering materials and consult your tax advisor concerning any applicable tax consequences of owning structured investments that may apply to you.

Informed investing
When considering any structured investment, understand the type of protection it offers as well as its pay-out potential by working with a qualified financial professional and carefully reviewing the offering documents before investing. And read on with our Structured Investments in Action series to discover more about how structured investments can be used to pursue growth or income objectives.

To learn more about how risk-managed and alternative solutions can be used within a diversified portfolio, visit simon.io/engage.

©2022 SIMON Markets LLC. All Rights Reserved. | 2022.01

STRUCTURED INVESTMENTS ARE CONSIDERED COMPLEX PRODUCTS AND MAY NOT BE SUITABLE FOR ALL INVESTORS.

This material is intended as general background information, for educational purposes only, and this material should not be used as a primary basis to make an investment decision. The material provides a general overview of the products described, and actual financial instruments may differ materially from those described. No person should consider investing in an instrument on the basis of these materials. Any investment decision should be made only after carefully reviewing the applicable prospectus. This does not constitute legal, accounting or tax advice, and the recipient should consult with his or her legal, accounting or tax adviser regarding the instruments described in this material.

This material is for informational purposes only and is not to be construed as a recommendation or an offer or solicitation to buy or sell any security, financial product or instrument, or otherwise to participate in any particular trading strategy. In providing information on hypothetical, generic structured investments, SIMON is not recommending a specific security, nor does it recommend investing a certain percentage of a portfolio to one structured investment. Before investing in any product, you should review the prospectus or other offering documents, which contain important information, including the product’s investment objectives or goals, its strategies for achieving those goals, the principal risks of investing in the product, the product’s fees and expenses, and its past performance.

Please note that there is no public secondary market for structured investments. Although the issuer may from time to time make a market in certain structured investments, the issuer does not have any obligation to do so and market making may be discontinued at any time. Accordingly, you must be prepared to hold such investments until maturity. Any or all payments are subject to the creditworthiness of the issuer. SIMON Markets LLC operates a technology platform that makes available offerings of structured investments and annuities to financial professionals. In operating this technology platform, SIMON Markets LLC earns revenue based on the volume of transactions that take place in these products and would benefit by an increase in sales for these products.

Securities products and services offered by SIMON Markets LLC, a broker-dealer registered with the U.S. Securities and Exchange Commission, a member of FINRA / SIPC. Annuities and insurance services provided by SIMON Annuities and Insurance Services LLC. Please visit www.simon.io for complete disclosures, including terms of use and privacy policy.

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