Understanding Issuer Credit Risk in Structured Notes

Structured notes are often introduced to investors through their payoff features: a buffer against the first 10% or 15% of losses, an enhanced upside participation rate, a fixed coupon tied to an index staying above a certain level. These features can be genuinely useful in a portfolio. But they tend to overshadow a more basic fact about how a structured note actually works, and that fact deserves equal attention.

A structured note is not a fund, and it is not a basket of securities held in trust for the investor. It is a debt obligation, an IOU, issued by a bank or financial institution. When an investor buys a structured note, they are lending money to that issuer in exchange for a promise to pay a return based on a specified formula.

That promise is only worth as much as the issuer's ability to keep it. If the issuing bank becomes insolvent, the payoff formula, no matter how well-designed, becomes irrelevant. The investor is left holding a claim against the bankruptcy estate of the issuer, in line with the bank's other unsecured creditors.

This is a meaningfully different risk profile than many investors assume. A structured note is not a bank deposit, and in most cases it is not backed by the Federal Deposit Insurance Corporation (FDIC). The notable exception is market-linked certificates of deposit (CDs), a specific structured product category that carries FDIC insurance up to applicable limits because it is legally structured as a CD rather than a note. Outside of that narrow category, structured notes generally carry no government insurance of any kind.

The risk described above is not theoretical. It played out publicly during the 2008 financial crisis. Lehman Brothers, at the time one of the largest investment banks in the world, filed for bankruptcy in September 2008. Lehman had issued a substantial volume of structured notes to retail and institutional investors in the years leading up to its collapse.

When Lehman filed for bankruptcy, the underlying market performance tied to those notes, whatever it happened to be, no longer mattered. Investors holding Lehman-issued structured notes found themselves standing in line as unsecured creditors of a failed institution, filing claims through the bankruptcy process alongside bondholders and other creditors. Recoveries varied and took years to resolve.

This episode is widely documented and is frequently cited in discussions of structured note risk precisely because it illustrated, in real time, what issuer credit risk actually means in practice.

Lehman is the example most often cited because it shows what happens when an issuer's structured notes are wiped out. Credit Suisse is a useful, more recent example precisely because it shows the opposite outcome, and the distinction matters for understanding how issuer risk actually plays out in practice.

When Credit Suisse ran into severe financial distress in March 2023, Swiss authorities did not put the bank through a formal resolution process of the kind that bails in senior creditors. Instead, they arranged an emergency takeover by UBS. The only instruments written down to zero in that process were Credit Suisse's Additional Tier 1 (AT1) bonds, a junior layer of bank capital, representing roughly CHF 16 billion. Structured notes are senior unsecured obligations of the issuer, meaning they rank above AT1 bonds in the bank's capital structure. As a result, outstanding Credit Suisse structured notes were not written off.

UBS Group acquired Credit Suisse Group in June 2023, but the two banks initially continued operating as separate legal entities. The full legal merger of the operating banks, Credit Suisse AG combining into UBS AG, was completed on May 31, 2024. Under Swiss law's principle of "universal succession," all of Credit Suisse AG's assets, liabilities, and contracts transferred automatically to UBS AG at that point, and Credit Suisse AG ceased to exist as a separate entity. UBS's own merger disclosures confirm that all rights and obligations of Credit Suisse AG connected to its structured products transferred to UBS AG. Outstanding Credit Suisse notes generally were not re-issued with new pricing supplements; the issuer of record simply changed by operation of law.

A few practical caveats are worth noting. A small number of legacy Credit Suisse exchange-traded notes were later terminated and cash-settled as UBS wound down overlapping product lines, a planned product wind-down rather than a default. UBS has also voluntarily repurchased a substantial amount of legacy Credit Suisse senior debt through tender offers at a premium as it simplified the combined balance sheet; a voluntary buyback is not the same thing as a failure to pay. Following the merger, payment on former Credit Suisse notes is an obligation of UBS AG, which carries its own issuer credit risk, generally considered stronger than Credit Suisse's standing had become, but, like any bank, not risk-free.

The bottom line: holders of Credit Suisse structured notes were not wiped out the way AT1 holders were. Their notes became UBS notes after the parent-bank merger and have continued to pay according to their original terms, or been called or bought back at the issuer's option under those terms. Investors evaluating any specific note should confirm its current issuer and review the offering documents or any supplemental indenture, since issuer identity can change over a note's life through mergers like this one.

Issuer credit risk cannot be eliminated from a structured note; it is inherent to the product. But it can be actively managed. Some of the more common approaches include:

Market risk relates to the performance of the underlying reference asset, an index, a stock, a basket of securities. If the underlying declines beyond a buffer or barrier, the note's payoff may be reduced accordingly.

Issuer credit risk is separate and applies regardless of how the underlying performs. Even a note with a favorable underlying market outcome pays nothing if the issuer cannot pay. These two risks exist independently of one another, and a full understanding of a structured note requires evaluating both.

• A structured note is an unsecured debt obligation of the issuing bank, not a bank deposit, and it is generally not government insured (with the narrow exception of FDIC-insured market-linked CDs).
• If the issuer becomes insolvent, investors become unsecured creditors in bankruptcy, as happened with Lehman Brothers-issued notes in 2008.
• Issuer risk doesn't always end in a loss: when Credit Suisse was taken over by UBS in 2023-2024, its AT1 bonds were wiped out, but Credit Suisse structured notes, senior to AT1, were not written off and became UBS obligations by operation of law.
• Issuer risk can be managed, though not eliminated, through issuer selection, diversification across multiple issuers, and ongoing monitoring of issuer credit ratings and CDS spreads.
• Issuer credit risk and market risk are two separate risks that both apply to every structured note, and evaluating a note fully means considering both.

Structured notes are complex investments that involve risks, including potential loss of principal, issuer credit risk, limited liquidity, and early redemption features that may limit returns. They are not suitable for all investors and, except for certain market-linked CDs within applicable FDIC limits, are not bank deposits or FDIC-insured. Past performance is not indicative of future results. Investors should carefully review the relevant offering documents and consult their advisor before investing.