A question that is commonly asked of me these days is “How can I earn a higher return on my fixed income?” It’s a dilemma many find themselves in with the current environment of low interest rates and the potential for inflation looming.
Many retirees and pre-retirees do not have the luxury of having a large part of their portfolio invested in fixed income instruments that will generate low single digit to potentially negative returns if inflation starts to spike. Furthermore, many investors oftentimes are not even aware of how little return (net of fees) they are earning from fixed income until a good financial advisor points this out on their statement.
Longevity risk is real for many and the challenge I have as a financial planner is how to help these clients achieve a targeted rate of return so they don't outlive their retirement savings. So I'm always looking for ways to help clients increase returns while staying within their risk tolerance and goals.
One possible solution for an investor who is looking for attractive (potentially double digit) yields on their fixed income, while also receiving limited protection from stock market declines, would be a contingent income note. This credit investment is a type of structured note so let's first answer the question:
What is a Structured Note?
A structured note (product) is a type of debt security, issued by any one of the large investment banks, where the return is linked to the performance of another asset, such as a stock or market index. While the majority of a structured note consists of a zero-coupon bond, the remainder is an options package which determines the payout/participation and protection levels. Each structured note has a finite maturity date (however some may be called prior to maturity) and is subject to the credit of the issuer.
Just like there are many different stocks, bonds, and mutual funds - there are many different types of structured notes. For purposes of this article, I will only cover what is referred to as a "Contingent Income Note" including examples of recent offerings that we participated in for select client accounts.
Why Invest in a "Contingent Income Note"
An investor who wants to generate a higher income stream than traditional fixed income securities or funds may want to consider these types of structured notes. An investor who is looking for average, annualized equity-like returns with limited protection from equity market declines may also want to consider these investments. Below are two examples of contingent income notes that we recently priced for our clients.
RECENT OFFERING EXAMPLE #1
For investors who were looking for a very attractive (15.25%) income stream and were willing to risk potential loss of principal (or missed monthly coupons) in the event of an extreme 30% market decline. 2
This note issued by Morgan Stanley Finance will pay a 15.25% annualized yield on a monthly basis unless the Nasdaq-100 (NDX), Dow Jones Industrials (DJIA) or Russell 2000 (RTY) stock index are down more than 30% on the monthly observation date.
Monthly coupons will not be paid if one of these referenced stock indices continue to be down more than 30%. Principal will be at risk if one of the referenced stock indices is down more than 30% at the 2.5 year maturity date (from inception date). Historical market declines of more than 30% are extremely rare as shown in the index links above.
RECENT OFFERING EXAMPLE #2
For investors who were looking for an attractive (8.3%) income stream with less of a chance for loss of principal unless there's a catastrophic 50% market decline. 2
This note issued by Morgan Stanley Finance will pay a 8.3% annualized yield on a monthly basis unless the S&P500 (SPX), Dow Jones Industrials (DJIA) or Russell 2000 (RTY) stock index are down more than 30% on the monthly observation date.
Monthly coupons will not be paid if one of these referenced stock indices continue to be down more than 30%. Principal will be at risk if one of the referenced stock indices is down more than 50% at the 2.5 year maturity date.
Note: The percentage of historical outcomes in hypothetical three year maturity DJIA, Russell 2000, or S&P500 50% barrier notes that have resulted in a loss is .09%. 1
What are the risks of a contingent income note?
When the issuer of the note defaults, the entire value of the investment principal is at risk of not being repaid. This is the same risk associated with investing in an other corporate bond. Investing with high quality banks with strong balance sheets reduces this risk. The vast majority of notes are issued by investment grade banks.
The maximum benefit of investing in a structured note is usually realized by holding until the maturity date. There is a secondary market but it's is limited to broker dealers and their affiliates and distributors. This means that any sales made prior to maturity could be at a discount to the current market value.
Losses are only protected according to the terms of the individual note. Principal is at risk if one of the referenced stock indices is down more than the barrier level at maturity. In the two examples above, these levels are 30% and 50%, respectively.
Keep in mind in the event of these extreme market loss scenarios alternative income producing options are also likely to decline significantly in value. and an investor keeps any coupon payments earned to date.
#4: Call Risk
Income notes usually have a call feature which means the bank can redeem the note before the maturity date. This means that investors will receive a return of their invested principal while keeping any interest payments paid to date. In the two examples above, these notes can be called back to the issuer after 3 months.
Please click on the offering hyper links above to see all risks and disclosures related to these specific note examples.
Why invest with a Registered Investment Advisor & Claro Advisors
While the traditional big banks offer a continuous "calendar" of offerings, it is almost always to the investor's advantage to work with an independent advisor that is experienced in working with structured notes. As a Registered Investment Advisor, we have access to a larger selection of multiple bank offerings and don't charge the fees and commissions that erode the income and protection terms of these products.
Furthermore, since structured notes are a specialty of our firm, we are proactive in leveraging our relationships to customize notes on a timely basis with superior pricing terms for our clients. In the case of the two examples above, these notes were deliberately created during short windows of volatility to maximize benefits and minimize risk to the investor. These notes were not available to clients of Morgan Stanley.
On a side note, we recently priced one of the best notes I've seen for investors who want growth and protection. This JP Morgan note is tied to the Nasdaq -100 Index and ARKK Innovation ETF and will offer a minimum return of 80% return as long as this index and ETF are flat or positive after 5 years. Investors can also receive up to a 40% return in the event of market declines. Click here for offering document.
- Source: Bloomberg, data from 12/31/86 through 9/30/20.
- Performance figures do not reflect the deduction of investment advisory fee. Client’s return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account; Investment advisory fees are described in the Advisor’s Form ADV Disclosure Brochure.
- This content is developed from sources believed to be providing accurate information. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.