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: So a question I get a lot from high-net-worth clients is: how do you stay in equities without taking a full market haircut when things go south? And the answer for a growing number of families is structured notes. Luna: Structured notes — these are the ones that package a bond with an option, right? So you get some downside protection but capped upside? Lucas: Exactly. At its simplest, a structured note is a debt instrument — usually issued by a bank — that pays a return linked to the performance of an underlying asset, like the S&P 500. But the trade-off is baked into the structure: you give up some upside in exchange for a buffer against losses. Luna: And these are not new, but I feel like they've become much more popular post-2022, when bonds and stocks both fell. People wanted something that could still offer equity exposure but with a floor. Lucas: Right. The structured note market globally is well over a trillion dollars now. And for ultra-wealthy families, it's not a core holding — it's a tactical tool. A way to get equity-like returns on a portion of the portfolio without taking full market risk. Say you've got a $50 million portfolio; you might put 5 to 10 percent into structured notes as a risk-mitigating sleeve. Luna: So let's get into the mechanics. The most common type I see is a buffered note. How does that actually work? Lucas: So a buffered note typically offers a downside buffer — say 20 percent. That means if the underlying index falls by up to 20 percent over the note's term, you don't lose a penny. Your principal is protected for that first 20 percent of losses. But if the index falls more than 20 percent, you absorb the losses dollar for dollar beyond that buffer. Luna: And the upside is capped, correct? So if the index goes up 25 percent, you might only get 10 or 12 percent. Lucas: Exactly. The cap is determined by the option market when the note is issued. In exchange for that downside buffer, you sell a call option that limits your upside. So the issuer — a bank like JPMorgan or Goldman Sachs — essentially buys a put option for the buffer and sells a call option to finance it. The net cost determines the cap. Luna: And this is typically a structured product — not a security you can just buy on the exchange. You're buying a note from the bank, so there's credit risk involved. Lucas: That's the biggest catch. It's an unsecured debt obligation of the issuing bank. If the bank goes under, you could lose your principal even if the market didn't fall. So families tend to stick with highly-rated institutions, and they diversify across issuers. Also, these notes are not liquid — you can't just sell them on a secondary market easily. You might get a price from the issuer, but it could be below fair value. Luna: And there's also the opportunity cost of dividends. When you own an S&P 500 index fund, you get the dividend yield — roughly 1.3 percent currently. But with a structured note, you typically don't get dividends. The return is based on the price return of the index, not total return. Lucas: Right. So the effective cap might be 12 percent, but if the index returns 10 percent price appreciation plus 1.3 percent dividends, you'd have been better off in the index — until the market drops. The real value of structured notes is in scenarios where the market is flat or down. Let me give you a concrete example. Luna: Please. I love the numbers. Lucas: So I worked with a family office last year — a client with about $30 million in liquid assets. They were worried about a correction but didn't want to go to cash and miss a rally. We put $2 million into a two-year buffered note linked to the S&P 500, with a 20 percent buffer and a 12 percent cap. Luna: So if the S&P drops 15 percent over two years, they get their full $2 million back? Lucas: Exactly. No loss. If it drops 25 percent, they lose 5 percent — because the buffer covers the first 20, and they absorb the remaining 5. If it rises 30 percent, they get 12 percent. So they cap their upside but sleep better. Luna: And what actually happened? The S&P was up about 8 percent over that period, so they got 8 percent — which is less than the index return but still positive, and they had peace of mind. Lucas: Correct. And that's the trade-off. For some families, the psychological benefit alone is worth it — they stay invested instead of panicking and selling at the bottom. But structured notes aren't free. In addition to credit risk and lack of liquidity, there are fees embedded in the note. The bank's cost to structure it is typically 1 to 2 percent annually, but that's built into the cap, not an explicit fee. Luna: So you really need to read the term sheet carefully. There's also autocallable notes — those can be called away early if the index hits a certain level, which can shorten your holding period. Lucas: Yes, autocallables are another popular variant. They typically pay a high coupon — say 8 percent annually — but if the index is at or above its initial level on a call date, the note is redeemed early and you get your principal back plus the coupon. So you might only get that high return for one year instead of three. Luna: And that can be frustrating if you were expecting a longer-term yield. But for families with a view that markets will be range-bound, it can work well. Lucas: Exactly. And then there are principal-protected notes — these guarantee 100 percent of your principal back at maturity no matter what. But the upside is usually much lower, because the bank has to buy a zero-coupon bond to cover the principal, and only the leftover money goes into options. So your participation rate might be only 50 to 70 percent of the index's upside. Luna: So you're trading upside for safety. It's a spectrum: on one end, full equity risk with unlimited upside; on the other, a principal-protected note with partial upside; in the middle, buffered notes with a cap. Lucas: Right. And ultra-wealthy families often use structured notes for specific purposes: hedging concentrated stock positions, generating income in retirement, or simply as a tactical allocation when valuations are high. A family with a single-stock position — say, $10 million in a tech stock — might use a structured note to monetize that stock while limiting downside risk. Luna: How does that work? They're using the stock as collateral? Lucas: No, they might sell the stock and use the proceeds to buy a structured note linked to a diversified index. But they could also use a structured note that references their own stock — though that's more complex and less common. More typically, they'll use a structured note as a substitute for selling. They want to stay exposed to equities but with a floor, so they move from direct stock to a note that references the broad market. Luna: And in a rising interest rate environment, the bond portion of the note becomes more attractive, because yields are higher. That actually boosts the cost of the put option, so caps might be lower. Lucas: Yes, the pricing is dynamic. Higher rates mean the zero-coupon bond that backs the principal is cheaper, so you have more money to buy options. But higher rates also affect option prices. It's a net effect. Right now, with rates around 4.5 percent on the short end, structured notes are actually offering decent caps compared to a few years ago. Luna: So what's the typical minimum investment for these? I know some are available through wealth management platforms, but for truly bespoke notes? Lucas: For a custom note from a major bank, you're looking at $1 million minimum — sometimes $5 million for more complex structures. But there are also retail structured notes sold in increments of $1,000 — though those are less customizable. For ultra-wealthy families, the family office often negotiates terms directly with the bank's structured products desk. Luna: And they can negotiate on the cap, the buffer, the term — it's essentially a private placement. Lucas: Exactly. And that's where the relationship matters. A family office that places $50 million a year in structured notes has leverage to get better terms. They might get a 15 percent cap instead of 12 percent on the same underlying. Luna: So it's not a one-size-fits-all product. You really need to understand your own portfolio and risk tolerance before diving in. Lucas: Absolutely. And one more thing: structured notes are often misunderstood as 'safe' because of the buffer. But they are not fdic insured. They are unsecured obligations of the issuer. The buffer is a contractual feature, but it's only as good as the bank that promises it. So diversification across issuers is critical. Luna: And we should mention the tax treatment — because that's always a factor for high-net-worth families. Lucas: Right. Structured notes are typically taxed as ordinary income upon maturity or sale, not as capital gains. So the return is taxed at your ordinary income rate, which can be higher than long-term capital gains. That's a disadvantage for taxable accounts. Many families hold them in IRAs or trusts to defer or avoid that tax hit. Luna: Good point. Also, if you hold a note to maturity, you avoid the complexity of mark to market accounting — you know exactly what you'll get. But if you sell early, the tax treatment can get messy. Lucas: Right. So structured notes are not a set-it-and-forget-it product. They require monitoring, understanding, and a clear purpose. But for the right family, they can be a powerful tool to stay invested with a safety net. Luna: And I think that's a good note to end on — no pun intended. Lucas: Ha! Well, let's keep going one more beat. You know, doing these episodes — we dig into these topics because we genuinely find them fascinating, and because listeners tell us they help. It's a labor of love, and we keep it ad-free intentionally. Luna: Yeah, and a small group of listeners already helps make that possible. If you've gotten value from these conversations, you can support the show at buy me a coffee dot com slash fexingo. It's a simple way to keep the podcast rolling. Lucas: And it really does make a difference. So thank you to those who already chip in. And for everyone else, next episode we're going to look at how wealthy families are using private credit as an alternative to traditional fixed income — that's a big topic given the current rate environment. Luna: Looking forward to it. Until next time.