Why Structured Notes?
From: bluetoad.com
A Unique Source of Yield in a Low-Interest Rate World
The fallout from the COVID-19 pandemic and the monetary policy response has challenged investors searching for yield. Equity dividends are no longer as safe as they once were, and interest rates are near historic lows with the likelihood that they will stay lower for longer. This challenge has investors looking for unique sources of yield. We believe, if understood and implemented correctly, structured notes present an opportunity to find a unique source of yield.
A structured note is a financial instrument generally issued by large well-known financial institutions. Structured notes are not one asset class, but a type of product structure that is created to meet different client objectives, such as income, growth, or principal protection. The terms vary both in time to maturity and degrees of market exposure. Investments in structured notes are not generally riskier than investments in mutual funds or hedge funds; they just have a different structure. This different structure allows structured notes to provide a unique value proposition that mutual funds and hedge funds are not set up to provide.
We think a unique opportunity to find yield today is in a type of structured note called an Income note. An Income note provides an investor with the opportunity to receive above-average periodic income payments (monthly or quarterly). The upside potential on the Income notes is simply the coupon yield. The principal is usually protected up to a certain downside level (often in the 20-40% range) in an underlying asset (often standard equity indexes). If the underlying asset drops below the downside level, the principal is no longer protected, and the principal value is linked to the underlying asset and rises or falls as the underlying asset rises or falls until maturity. A prudent way to mitigate the impact of a potential breach of the downside level is to simply build a ladder of Income notes. If the underlying asset does not drop below the downside level, the investor receives their coupon payment plus their principal.
An Income note is not a substitute for a bond, but it can provide diversification benefits to a bond allocation. Specifically, it generates income without assuming interest rate risk, making it a unique source of yield and providing overall portfolio diversification benefits. Our experience with Income notes with maturities in the 12-15-month range suggests that the average yield advantage over the broad high yield bond index has been around 200 basis points (2%). At the same time, the downside risk has been commensurate with high yield bonds.
