Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Structured Notes for Downside Protection
Transcript
- Lucas: If you're an ultra-high-net-worth family with, say, fifty million dollars in liquid assets, you have a problem that most investors would love to have — you can't afford to take a big loss, but you also can't afford to miss out on equity returns entirely. Luna: Right, because if you just pile everything into ten-year Treasuries yielding four and a half percent, you'll barely keep pace with inflation after taxes. But if you go all-in on the S&P 500, a fifty percent drawdown wipes out twenty-five million dollars. Lucas: Exactly. So private banks and wealth managers have been pushing a product that sits right in that middle ground — structured notes. Specifically, principal-protected notes linked to equity indexes. And these things have gotten enormous. Last year, U.S. sales hit about one hundred twenty billion dollars, which is a record. Luna: That's a lot of custom paper. But for listeners who haven't encountered them — what is a structured note, basically? Lucas: Think of it as a hybrid security. It's a debt instrument issued by a bank — typically a money-center bank like JPMorgan, Goldman Sachs, or Morgan Stanley — but instead of paying you a fixed coupon, the return is tied to the performance of an underlying asset, most commonly the S&P 500. The key feature is the principal protection. At maturity, you get back at least your original investment, regardless of what the market did. Luna: So it's like a bond with a guarantee, but the upside is linked to stocks. How do the banks make that work financially? Lucas: The note is essentially two pieces packaged together. The issuer takes, say, ninety percent of your principal and buys a zero-coupon bond that matures at par in three years. That bond, at current rates, might cost about eighty-eight cents on the dollar. The remaining twelve cents goes into a call option on the S&P 500. If the market goes up, the option pays out. If it goes down, you lose the option premium, but the bond still delivers your principal back at maturity. Luna: So the downside protection is real, but it's not free. You're giving up the dividends on the stocks you would have owned, plus the upside is capped. Lucas: That's the trade-off. A typical three-year principal-protected note linked to the S&P 500 might offer one hundred percent participation up to a cap of, say, sixty percent total return over three years. So if the S&P goes up fifty percent, you get fifty percent. If it goes up eighty percent, you still get sixty — that's the cap. And if it goes down forty percent, you get zero return, but you get your principal back. Luna: Let's test that with real numbers. Say you put five million dollars into such a note in early 2022, right before the bear market. The S&P fell about nineteen percent that year. Your note would have matured in early 2025, and the index had recovered and then some — it was up about thirty percent cumulatively over those three years. So you'd have gotten exactly that thirty percent, minus the cap if it applied, but you'd have slept through the nineteen percent drawdown. Lucas: That's the pitch. But the cap matters. If you'd bought the note in early 2020, right after the COVID crash, the S&P rallied something like ninety percent over the next three years. You'd have been capped at sixty. You left thirty points on the table. So these notes are really a behavioral tool — they keep you invested during the scary parts. Luna: And banks love issuing them because they collect fees, they get to use the zero-coupon bond for their own funding needs, and the option premium is pure profit if the cap is hit. It's a nice business. Lucas: It is. But there's also issuer credit risk. The note is an unsecured obligation of the issuing bank. If JPMorgan were to fail — unlikely but not impossible — your principal protection is only as good as JPMorgan's balance sheet. That's different from FDIC insurance or Treasury bonds. Wealthy families tend to buy these from the strongest banks precisely for that reason. Luna: Right. So the note is a bet on the issuer's creditworthiness as much as on the market. How do advisors typically position these in a portfolio? Lucas: They're often used as a bond substitute. If a family has a fixed-income allocation yielding four and a half percent, they might replace some of that with principal-protected notes that could return anywhere from zero to sixty percent over a three-year horizon. The note has higher expected return but also higher variance — though the variance is asymmetric because you can't lose principal. Luna: But you can lose purchasing power. If inflation runs at three percent over three years, a flat zero return means your real principal has eroded by about nine percent. So the protection isn't absolute. Lucas: Absolutely. And that's why these notes are most popular in low-inflation, moderate-return environments. The sweet spot for an issuer is when interest rates are high enough to make the zero-coupon bond cheap, and volatility is moderate to high, so the option premium is expensive but not prohibitive. That's exactly the environment we've had coming out of 2023 and 2024. Rates were elevated, but inflation was coming down, and the market was jittery. Luna: Speaking of the environment — if our conversations about wealth management and alternative strategies have helped you think about your own portfolio differently, listener support is what keeps this show free and ad-free. If you'd like to help, you can find us at buy me a coffee dot com slash fexingo. No pressure, just gratitude. Lucas: Yeah, that's right. And it makes a real difference. Now, back to structured notes — there's a variant that's become even more popular among ultra-wealthy families in the last eighteen months: the autocallable structured note. Luna: Oh, autocallables are fascinating. They're riskier than principal-protected notes, but the potential returns are higher. Walk us through one. Lucas: An autocallable note typically has a shorter term — say, two years — and it's callable on observation dates, often every six months. If the underlying index is at or above its initial level on an observation date, the note is called, and you get your principal back plus a fixed coupon. If it's below, the note continues. At maturity, if the index hasn't recovered, you could take a loss — usually one-for-one with the index decline. Luna: So it's principal-protected only if the note is called early. If the market drops and stays down, you're exposed to the full downside. Lucas: Exactly. For a wealthy family that's comfortable with that risk, the trade-off is a much higher coupon — often eight to twelve percent annualized. The issuer can offer that because the chance of early call is high in normal markets, and the option premium they collect by selling the put spread is generous. These notes are essentially a bet that the market won't be significantly lower at any observation date. Luna: And there's a behavioral trap there, too. If the market drops early and stays down, the investor is locked in, hoping for a recovery that might not come. I've seen families end up holding notes that have lost twenty percent and have no chance of being called until the market recovers. It's a psychological anchor. Lucas: That's a real risk. The key for advisors is to match the note structure to the family's actual risk tolerance and cash-flow needs. A family that needs liquidity in two years for a real estate purchase shouldn't buy an autocallable that might not call. They'd be better off with a principal-protected note that guarantees the money is there at maturity. Luna: Right. And for families that are truly long-term, there's another variation: the buffer note. It absorbs the first, say, ten percent of losses, and then passes through losses after that. That gives you some downside protection but not full protection, and in exchange you get higher upside participation. Lucas: Buffer notes have become very popular in the last two years. They're essentially a way to 'self-insure' the first few points of market decline. For a family that thinks a ten percent correction is the worst they'll see in a given year, it's a cheaper way to get equity exposure than full principal protection. Luna: And do you see structured notes becoming more common in the mass-affluent space, or will they remain primarily a high-net-worth product? Lucas: They're already trickling down. Some online brokerages now offer structured notes with minimums as low as ten thousand dollars. But the bespoke, customized notes that really match a family's specific view on interest rates, volatility, and market direction — those still require a private banking relationship and usually a minimum of one to five million dollars per note. That's where the real value is, because the terms can be negotiated. Luna: Negotiated how? Lucas: If you're committing ten million dollars, you can ask for a higher cap, a shorter maturity, or a different underlying index. The bank can tailor the option structure. It's not a commodity product at that level. It's a derivative contract written specifically for you. Luna: That's the power of being an ultra-wealthy family. You don't just buy products — you have products built for you. Lucas: Exactly. And structured notes are one of the cleaner examples of that. The product isn't inherently good or bad — it's a tool. Used well, it protects a portfolio from tail risk while keeping equity upside. Used poorly, it caps returns and exposes you to credit risk you didn't fully understand. Luna: So the takeaway for our listeners: if an advisor pitches a structured note, ask three questions. First, what is the issuer's credit rating and how diversified is the bank? Second, what is the upside cap and how does it compare to historical returns of the underlying? And third, what is the true cost — including forgone dividends and any embedded fees? Lucas: Those three questions will get you ninety percent of the way to understanding whether the note is a good fit. The rest is just math — and with the right advisor, that math can work in your favor. Luna: Lucas, any final thought on where structured notes fit in the current market, mid-2026? Lucas: I think we're in a period where caution is warranted. Valuations are high, inflation is sticky but not surging, and central banks are signaling rates will stay higher for longer. That's the exact environment where principal-protected notes with moderate caps can help families stay invested without panic-selling in the next correction. They're not magic, but they're a rational tool for a nervous market. Luna: And maybe the best use is as a bridge — something to get you from the uncertainty of today to the clarity of three years from now, without losing sleep along the way. Lucas: That's it exactly. Thanks, Luna. Luna: Thanks, Lucas. We'll see you next time.