Structured notes

We have omitted a discussion of bonds as you probably know about and understand that alternative. The purpose of this site is to explain investments that pay more than market rates. It is essential that you fully understand these instruments before investing, as there is always a trade off of these four items:

• Length of term
• Volatility
• Rate
• Credit risk (easily reduced or eliminated by investing on high grade or guaranteed instruments).

Let’s take the example of a note backed by GNMA, a federal agency. GNMA loans money so that people can purchase homes. If you invest in these notes, your payments are guaranteed. To have these notes be more suitable for various investors, a financial institution might split the note into two portions—the principal repayment portion and the interest portion. You are able to buy one portion or the other. Each portion is priced based on assumptions about interest rates and the rate of mortgage prepayments.
Let’s say you buy the portion where you receive the principal. As you know, as people make their mortgage payments, part of each payment is principal which you receive, as the investor. When interest rates fall, people tend to refinance and you will get your principal payments faster than expected. This increases your yield (the faster you receive a stream of payments, the higher your yield).
The opposite can also happen. Interest rates rise, and the length of your investment (the time it takes to receive your principal) stretches out. This reduces your yield as money received in the future has a lower present value today. These changes in yield cause the market value of these securities to change dramatically. Changes in market value are only important if you need to sell into the market.

Your funds are backed by a government agency and you will eventually get all of the principal payments, but the yield, market value and length of your investment can vary greatly. These types of securities are great for people who love to guess about the future because they can put their money where their mouth is.

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