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Accelerated return notes, or ARNs, are debt instruments and a type of structured investment product (SIP) which provides access to higher returns, depending on how the underlying index or stock performs.
These products have short or medium-term maturity dates, with variable returns that can fluctuate with the market value of the linked asset or cumulative asset performance if related to multiple assets.
As with every investment, there are pros and cons. ARNs have capped returns, cannot provide exponential profitability, and do not have downside protection, safeguarding investors from capital loss if their selected security falls.
However, where investors are confident that their linked index or asset will appreciate, the returns available through leverage are higher than comparable products. Much depends on investor confidence, market knowledge, and accurate forecasting.
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How Do Accelerated Return Notes Work?
ARNs are structured investment products (SIPs) with several elements in capital protection, fixed or variable returns, maturity dates, investment values and the securities they are linked to.
Underlying assets can include the following:
They can also be backed by a basket of assets, so a great deal of customisation is available based on the investor’s preferred securities and risk tolerance.
ARNs are subject to different levels of risk exposure and equally changeable returns, and as with most investments, the higher the risk, the higher the reward. The basis is the traditional asset or security, similar to a bond, but adapted to include alternative payment features and payoff calculation processes.
A conventional bond pays investors an annual coupon, representing the interest rate payable, calculated as a percentage of the bond value, paid periodically from the issue date until the bond reaches maturity. ARNs differ because the payoff is not dependent on the face value of the product – instead, they are calculated against how the underlying asset performs.
Accelerated Return Note Risks
ARNs have capped returns, so investors have a ceiling level they can achieve. If the product does not have a corresponding level of downside protection, there is a more significant risk that investors will make a net loss without recouping their original capital.
Investors should be confident that whichever stock or index they reference will appreciate – even if the value increases by a minor percentage, this will generally mean the ARN produces a return.
The product is closed past maturity, and there is no impact, but investors carefully forecast market movements based on their required maturity date.
There is a fair degree of risk, and ARNs are not normally considered appropriate products for investors who expect a guaranteed return of their capital once the product matures, as they would with a conventional bond.
ARNs also transfer the entire downside risk to the investor, which means there is the possibility of a zero return plus capital loss. This factor contrasts with other products, which normally have uncapped returns in return for the lack of downside risk protection.
Downside risk estimates the potential loss if the security underperforms or declines below the initial valuation and is the most the investor could lose if the asset linked to the ARN does not move as anticipated.
Accelerated Return Note Example
Our illustrative ARN is linked to the FTSE 100 and has the following product features and terms:
- Maturity period: two years
- Starting index rate: 2,000
- Capital invested: £100
- Return: twice positive index performance
- Maximum return: 30 per cent
- Downside protection: zero
If the index appreciates within the next two years, the investor stands to achieve double those returns. However, this is capped at a maximum of 30 per cent gain, or £30.
The exact outcomes will depend on how the FTSE 100 is performing at the maturity date. If the index has appreciated to 2,500, the investor receives double the 25 per cent gain, or 50 per cent, but is exposed to their 30 per cent cap. They receive a maximum payout of £130.
Another scenario might be that the index has appreciated 10 per cent, providing a doubled return of 20 per cent according to the ARN terms. The investor, therefore, receives £120 at the maturity date.
However, if the index does not appreciate as the investor expects and instead falls to 1,500, it represents a decrease of 25 per cent. The product does not offer any downside protection, and the investor is exposed to 100 per cent of the value.
In this final example, they receive back £75 of their original capital, a net loss of 25 per cent.
Understanding the balance between potential gains and loss exposure is essential. An investor could lose all their capital if the markets move unfavourably, regardless of whether that happens one day before maturity and previously appreciated throughout the product’s lifetime.
Accelerated Return Notes FAQ
Potentially, yes. ARNs do not give investors any guarantees that they will recover the total value of their initially invested capital at the maturity date. This absence of downside protection is the most significant risk.
If the underlying asset depreciates, the investor accepts total exposure, deducted from their capital, before the balance is returned.
An ARN does not operate like a fixed-rate bond and does not pay periodic interest during the product’s lifespan. Instead, the investor receives the return and any repaid capital at the term end, calculated based on the performance of the linked assets, such as currencies, commodities, or securities.
Most ARN product packages offer a multiple of the gain, such as two or three times the positive movement of the asset, although they have a returns cap, so they do not provide unlimited returns or exponential profitability if the index or stock appreciates significantly.
Investors need to select reference assets with care because their return, and capital, are reliant on the security increasing in value before the maturity date. ARNs can be linked to several assets or baskets of assets, including indices, stocks, currencies, derivatives, and commodities.
The unique nature of ARNs means that the fee structure also depends on the underlying asset performance, so understanding product charges is also important when assessing potential returns or losses.
The ARN issuer will calculate the value of the linked asset once the product reaches maturity. Most products provide a payoff based on the increase multiplied by a predetermined amount, normally two or three times.
There is, though, a capped return, so if the linked asset appreciates significantly, this will not necessarily pass to the investor through a higher return.
If the asset decreases during the product period, the payoff is based on the original capital investment, less all the downside loss, since there is no exposure protection.
These unsecured debt instruments were first introduced to the market in 2010 and were offered by the Bank of America and Merrill Lynch as an alternative structured note.
Debt securities were initially linked to gold spot prices, using derivatives to provide investors with leveraged returns with lower loss exposure for retail investors.
ARNs were packaged as an investment product with accelerated returns, hence the name. They were marketed as providing greater profits based on well-established stocks and indices, with two or three-times positions against asset appreciation.
Most ARNs had returns capped at 18 to 25 per cent, although there are now some products with higher return limits, depending on the issuing financial institution, the capital invested, and the underlying asset.
While ARNs proved popular, they were not exchange-traded and had little liquidity, with some banks removing this structured product. However, with increasing market volatility and uncertainty, this investment remains an option as an alternative to conventional fixed-rate debt instruments such as government or corporate bonds.
ARNs are a type of structured investment product (SIP). These packaged investments are usually created by investment banks for institutional investors such as organisations and hedge funds, although some SIPS are available to retail investors.
The scope, possible returns, risk, and complexity vary between each SIP because these are customised but are commonly linked to traditional security. The difference is in the non-traditional payoff features, which depend solely on the underlying asset performance.
Other debt instruments, such as bonds, are generally more simplified and carry considerably less risk since an ARN is unsuited to investors that require a guaranteed return on their capital or, indeed, a return on the original capital investment value.
SIPS, including ARNs, are accessible as alternatives for retail and institutional investors alongside more mainstream products, such as mutual funds, ETFs, stocks, and bonds.
For retail investors, another structured investment product with capital protection built in is likely preferable, with structured deposits, another option, acting similarly to a fixed-rate bond, and yet with a different calculation basis and higher possible returns.
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