By Peet Serfontein
Structured notes are a prominent subset of structured products that are typically issued by banks and large financial institutions, often for a fixed term, and are designed to deliver pre-defined payoffs linked to the performance of an underlying asset or market. Unlike equities or unit trusts, structured notes do not provide open-ended participation in market movements. Instead, they follow clearly defined rules that determine returns under different scenarios. These instruments combine elements of bonds and derivatives, creating tailored outcomes but also introducing specific risks that investors do not face to the same degree in traditional instruments.
Since outcomes are contractual and rule-based, investors benefit most when they understand how the note is constructed, what must happen for coupons or growth to be earned, and what could cause capital to be at risk or returns to be limited.
What is a structured note?
A structured note is a debt instrument issued by a financial institution. When an investor buys a structured note, they are effectively lending money to the issuer for a fixed period. In return, the issuer promises to repay capital and/or income according to a formula that is linked to an underlying reference. This reference may be a Johannesburg Stock Exchange (JSE) equity index (such as the Top 40), a basket of shares, a commodity, interest rates, inflation, or even offshore markets.
Since the note is a form of debt, the investor ranks alongside other creditors of the issuer. This means that repayment depends on market performance and the issuer's financial strength. Even notes described as "capital protected" rely on the issuer's ability to honour its obligations at maturity.
The two core components of a structured note
The funding or bond component
A portion of the investor's capital is allocated to an interest-bearing instrument. In capital-protected notes, this component is structured to grow to meet the promised capital repayment at maturity (for example, through a discounted bond that accretes over time). The higher the prevailing interest rates, the less capital needs to be set aside for this purpose. However, when rates fall, issuers often need to reduce coupons, tighten caps, increase barriers or extend terms to deliver the same outcomes. In South Africa, relatively high interest rates compared to developed markets have historically made it easier to design notes with capital protection or enhanced coupons.
The derivative component
The remaining portion of the investment is used to create derivative exposure, typically through options. These options determine how the note responds to market movements. For example, buying call options, which gives investors the right but not the obligation to buy an underlying asset at a predetermined price, and provides upside exposure to an index; while selling options can generate premium income to fund coupons or provide capital protection.
The derivative component is where most of the complexity and risk of a structured note resides. Option prices are influenced by factors such as market volatility, dividends, interest rates and correlation (for baskets). As these inputs change, so does the pricing of the structured note at inception and, where applicable, its secondary-market value.
How returns are generated
Structured notes follow a rules-based payoff structure. These rules are set at inception and remain in place until maturity or early redemption. A simplified lifecycle looks as follows:
Key features that shape structured notes
Several technical features determine how a structured note behaves. These features are not independent and are set to balance risk and return, which means improving one feature often requires a trade-off elsewhere, such as accepting a lower participation rate or higher downside risk:
The South African market context
Structured notes in South Africa are influenced by several local dynamics that shape pricing, terms and risk:
Regulatory and disclosure environment
Structured notes are subject to local financial regulation, requiring clear disclosure of risks and payoff mechanics. Despite this, investors must actively engage with the product documentation to fully understand outcomes.
Relationship to traditional investments
Structured notes occupy a hybrid position between asset classes, making them suitable for specific objectives rather than as replacements for core portfolio assets:
Structured note example
A South African investor invests R100 000 into a three-year equity-linked autocall note issued by a local bank and referenced to the FTSE/JSE Top 40 Index. The note has clearly defined rules at inception:
Risks specific to structured notes
Structured notes with the investor's time horizon and risk tolerance with key risks including:
Why structured notes are used by South African investors
Structured notes appeal to South African investors for several reasons:
For South African investors, structured notes tend to work best as complementary tools within a diversified portfolio, rather than as standalone investments.
