Growth notes

What Is Growth Notes?

Growth notes are a type of Structured Products, which fall under the broader financial category of structured products. They are debt instruments issued by Financial Institutions whose returns are linked to the performance of an Underlying Asset, such as an Equity Index, a single stock, a basket of securities, commodities, or currencies²⁴, ²⁵. Unlike traditional bonds that pay fixed interest, growth notes are designed primarily for Capital Appreciation and typically offer investors participation in the upside potential of the linked asset, often with some degree of Principal Protection²³. This hybrid nature combines elements of Fixed Income securities and embedded Derivative components²². Growth notes are customized investment tools, tailored to meet specific objectives, including diversification, yield enhancement, or access to non-traditional asset classes²¹.

History and Origin

The concept of structured products, including what would evolve into growth notes, gained prominence from the early 1990s, with significant growth in the U.S. market. Their evolution has been driven by the desire to offer investors tailored exposure to various markets and asset classes while potentially managing risk²⁰. Financial institutions continually innovate structured products to meet evolving investor and issuer needs, particularly in response to volatile markets and changing interest rate environments¹⁸, ¹⁹. Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), began issuing guidance on the sale of structured products, highlighting the importance of disclosure and suitability for investors due to their complexity¹⁷. For instance, NASD (the predecessor to FINRA) issued Notice to Members 05-59 in 2005 to provide guidance on firms' obligations when selling these products¹⁶.

Key Takeaways

• Growth notes are debt instruments issued by financial institutions, with returns linked to an underlying asset or index.
• They are primarily designed for capital appreciation, often providing a participation rate in the underlying asset's gains.
• Many growth notes offer some level of principal protection, which can shield against moderate losses in the underlying asset.
• Their structure includes a bond component and an embedded derivative, making them hybrid investment vehicles.
• Growth notes can offer customized exposure to specific market segments or strategies that might otherwise be unavailable to retail investors.

Formula and Calculation

The payoff formula for growth notes can vary significantly based on the specific terms and features. Generally, for a growth note with a participation rate and principal protection, the return might be calculated as:

This is the payoff at maturity if the underlying asset's performance is positive. If the underlying asset declines but stays within a protected barrier, the investor may receive their Initial Principal back.

Where:

• Initial Principal: The original amount invested in the growth note.
• Participation Rate: The percentage of the underlying asset's positive performance that the investor will receive. For example, a 70% participation rate means the investor receives 70% of the underlying asset's gains.
• Starting Index Level: The level of the underlying asset or index at the beginning of the note's term.
• Ending Index Level: The level of the underlying asset or index at the maturity of the note.

It's crucial to note that many growth notes also include a "cap" on the maximum possible return, regardless of how much the underlying asset increases. This means that even if the calculated payoff exceeds the cap, the investor will only receive the capped amount.

Interpreting the Growth Notes

Interpreting growth notes requires a clear understanding of their specific terms, as they are highly customizable¹⁵. Investors should focus on the defined Participation Rate and any embedded caps, which determine the upside potential. A higher participation rate generally means greater exposure to the underlying asset's gains, but this may come with trade-offs such as lower principal protection or a higher cap. Conversely, a lower participation rate might be offered in exchange for stronger downside protection.

It is also important to understand the level of Downside Protection offered. Some growth notes provide full principal protection at maturity, provided the issuer does not default, while others might have a "barrier" or "buffer" that only protects principal up to a certain percentage decline of the underlying asset¹⁴. If the underlying asset falls beyond this barrier, the investor may incur principal losses.

Hypothetical Example

Consider an investor purchasing a growth note with an initial principal of $10,000, linked to the S&P 500 Index. The note has a three-year maturity, a 75% participation rate, and 100% principal protection at maturity, assuming no issuer default. There is no cap on the upside.

• Scenario 1: S&P 500 increases. If the S&P 500 Index increases by 30% over the three-year term, the investor's gain from the index performance would be 75% of 30%, which is 22.5%.
  • Return on investment: $10,000 * (1 + 0.225) = $12,250.
• Scenario 2: S&P 500 decreases. If the S&P 500 Index decreases by 15% over the three-year term, due to the 100% principal protection feature, the investor would still receive their initial $10,000 principal at maturity.
• Scenario 3: S&P 500 remains flat. If the S&P 500 Index ends at the same level as the start, the investor would receive their initial $10,000 principal at maturity, as there is no positive return to participate in.

This example illustrates how a growth note can provide market exposure while mitigating downside risk through its Principal Guarantee feature.

Practical Applications

Growth notes are utilized by investors seeking to participate in market upside with some mitigation of potential losses. They can be particularly attractive in periods of Market Volatility or low interest rates, where traditional fixed income investments offer limited returns¹³. Investors might use growth notes to gain exposure to specific market sectors, commodities, or international markets that might otherwise be difficult or expensive to access directly¹².

For example, a high-net-worth individual looking to diversify their Investment Portfolio might use growth notes to get exposure to a specific foreign equity index, while maintaining a degree of principal safety not found in direct equity investments. These products can be structured to provide highly targeted investments tied to a specific risk profile and return requirements¹¹. However, it is important for investors to conduct thorough due diligence and understand the precise terms of any growth note they consider.

Limitations and Criticisms

Despite their potential benefits, growth notes, like other structured products, carry significant limitations and criticisms. A primary concern is their complexity, which can make it challenging for investors to fully understand how returns are calculated and what risks are involved¹⁰. The embedded derivative components can obscure the true costs and potential returns⁹.

Another significant drawback is Credit Risk. Growth notes are unsecured debt obligations of the issuing bank⁸. If the Issuing Bank faces financial distress or bankruptcy, investors could lose some or all of their principal, regardless of the underlying asset's performance⁷. A notable instance of this was the collapse of Lehman Brothers in 2008, where investors holding their structured notes lost nearly all of their original investment⁵, ⁶.

Furthermore, growth notes often suffer from Liquidity Risk. Many are not traded on public exchanges, or if they are, they may be thinly traded, making it difficult to sell them before maturity without incurring significant losses⁴. The pricing of growth notes can also be opaque, with embedded fees that are not always transparent and can significantly impact overall returns. Some structured notes also feature "call risk," where the issuer can redeem the note early, potentially forcing investors to reinvest at less favorable rates. Academic research has shown mixed results regarding the performance of structured notes, with some studies suggesting they may underperform a balanced portfolio of stocks and bonds, or even risk-free Treasury bills, on average³.

Growth Notes vs. Principal Protected Notes

While growth notes often incorporate principal protection, the distinction between "Growth Notes" and "Principal Protected Notes" (PPNs) lies primarily in their emphasis and typical payoff structures.

Growth notes focus on leveraging positive movements in the underlying asset for Enhanced Return, with principal protection as a secondary, albeit important, feature. PPNs, conversely, prioritize the return of capital, making any linked growth component a bonus. Both are types of Structured Investment products, but their risk-reward profiles are nuanced based on their specific terms.

FAQs

What is the typical maturity for growth notes?

The maturity of growth notes can vary, but they commonly have terms ranging from two to ten years. Investors typically need to hold the growth note until maturity to benefit from its principal protection features and full participation in the underlying asset's performance.

Are growth notes suitable for all investors?

No, growth notes are complex instruments and may not be suitable for all investors. They often involve Specific Risks such as credit risk of the issuer and limited liquidity. Investors should have a thorough understanding of these risks and how the note's payoff structure works before considering an investment. Due to their complexity, the Financial Industry Regulatory Authority (FINRA) has emphasized that firms must perform a reasonable-basis suitability determination before recommending these products².

Do growth notes pay dividends or interest?

Generally, growth notes are designed for capital appreciation based on the underlying asset's performance and typically do not pay regular Interest Payments or dividends directly. The return is realized at maturity based on the calculated payoff linked to the underlying asset. Some structured notes, however, are designed as "income notes" which do focus on generating periodic coupon payments, but growth notes are primarily growth-oriented¹.

How do fees impact growth notes?

Fees for growth notes are typically embedded within the product's structure rather than being explicit upfront charges. These fees, which cover structuring, hedging, and distribution costs, can reduce the overall potential return to the investor. Due to the lack of transparency in their fee structures, it can be challenging for investors to assess the true cost of these investments.