What’s Ahead:
- Selecting the right Structured Note payoff type can be tricky. This short guide can help clear some confusion.
- There are a handful of different styles, each with unique elements of upside potential for a note’s underlier.
- Navigating a note’s dynamics is more straight forward than many investors think.
Measuring Assets: Apples-to-Apples
To simplify the understanding of Structured Notes’ dynamics, it can be helpful to compare simple examples. The following exercise provides a side-by-side comparison of various Note types, enabling investors to comprehend how Structured Notes function independently and relative to other options.
In this exercise, each of the Structured Notes offers the same downside protection, specifically a -20% Soft Barrier Protection. Therefore, differences arise in terms of upside potential and the outcome profiles across different market environments.
The analysis focuses on the four most common types of Structured Note payoffs: Uncapped Growth, Capped Growth, Contingent Income, and Fixed Income.
Example Notes Compared to the Underlier
To begin this exercise, consider the following table that displays an Underlier (the S&P 500 Index) and four hypothetical Notes:*
| Asset | Full Principal Protection Threshold | Upside Multiplier (Participation) | Annualized Yield (Interest) |
|---|---|---|---|
| S&P 500 Index | 0% | 100% | |
| Uncapped Growth | 0% to -20% | 110% | |
| Capped Growth | 0% to -20% | 200%, Up to 30% Cap | |
| Contingent Income | 0% to -20% | 9.25%, Adjusted in Some Scenarios* | |
| Fixed Income | 0% to -20% | 8.0% |
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. Indicative of pricing as of 5/12/2023. Changes to terms and pricing should be expected. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
*-30% Underlier Scenario = 75% of Coupons Received. -40% Underlier Scenario = 50% of Coupons Received. -50% Underlier Scenario = 25% of Coupons Received.
Leaderboard Across Varying Market Environments
The next part of the exercise involves ranking the securities’ returns across a range of market conditions. By modifying the Underlier’s return, we can determine the returns of each Note. This allows us to create a leaderboard that ranks the Notes and the Underlier in each market-return scenario.
| Underlier Return | 1st Place | 2nd Place | 3rd Place | 4th Place | 5th Place |
|---|---|---|---|---|---|
| 50% | Uncapped | Underlier | Capped | Contingent | Fixed |
| 40% | Uncapped | Underlier | Capped | Contingent | Fixed |
| 30% | Uncapped | Capped and Underlier | Contingent | Fixed | |
| 20% | Capped | Uncapped | Underlier | Contingent | Fixed |
| 10% | Capped | Contingent | Fixed | Uncapped | Underlier |
| 0% | Contingent | Fixed | Underlier, Uncapped, and Capped | ||
| -10% | Contingent | Fixed | Uncapped and Capped | Underlier | |
| -20% | Contingent | Fixed | Uncapped and Capped | Underlier | |
| -30% | Fixed | Contingent | Underlier, Uncapped, and Capped | ||
| -40% | Fixed | Contingent | Underlier, Uncapped, and Capped | ||
| -50% | Fixed | Contingent | Underlier, Uncapped, and Capped | ||
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
According to the results, the Uncapped Growth Note example outperforms the Underlier in all positive scenarios, because its multiplier is above 100%. It also outperforms when the Underlier falls within the protection threshold of 0% to -20%.
Capped Growth Notes outperform most when the Underlier has mild positive returns, due to the 200% participation rate.
Contingent Income Notes tend to lag when the Underlier has very high returns, but performs well in sideways to negative markets.
Finally, Fixed Income Notes were the weakest in strong markets and strongest in weak markets.
The Underlier underperforms or ties the example Notes in every hypothetical situation when it posts a +10% or lower return.
Magnitude of Performance Differences
The numbers used to generate the leaderboard can be found in the table below. In cases where the Structured Note has a higher return than the Underlier, the number is positive. Conversely, if the Underlier has a higher return, the number in the table is negative. This enables us to identify the “winners or losers” and determine the magnitude of the differences.
The numbers assume a two-year period to determine the return of Income Notes:
| Underlier Return | Uncapped Growth vs Underlier | Capped Growth vs Underlier | Contingent Income vs Underlier | Fixed Income vs Underlier |
|---|---|---|---|---|
| 50% | 5% | -20% | -32% | -34% |
| 40% | 4% | -10% | -22% | -24% |
| 30% | 3% | 0% | -12% | -14% |
| 20% | 2% | 10% | -2% | -4% |
| 10% | 1% | 10% | 9% | 6% |
| 0% | 0% | 0% | 19% | 16% |
| -10% | 10% | 10% | 29% | 26% |
| -20% | 20% | 20% | 39% | 36% |
| -30% | 0% | 0% | 15% | 16% |
| -40% | 0% | 0% | 11% | 16% |
| -50% | 0% | 0% | 7% | 16% |
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
The table shows that the most significant outperformance number is associated with Contingent Income Notes when the Underlier is down by 20%. In this scenario, the Contingent Income Note outperforms by 39%.
Conversely, the worst outcome is observed for Fixed Income Notes when the Underlier rallies. Since Fixed Income Notes have the lowest upside potential, their return relative to the Underlier lags the most in this analysis.
Leaderboard Across Varying Market Environments, Underlier Dividend Included
An essential consideration for Structured Notes is that they do not receive the dividend of the Underlier. Investors should take this into account before investing in Structured Notes since it could potentially cause the Underlier to shift from losing to winning in specific scenarios.
Structured Notes are typically held for one to five years, with an average of two years. To make a meaningful real-world comparison, the table below includes an additional column representing the Underlier return with a 1.5% dividend over two years. This provides a proxy for investing in an S&P 500 ETF to accurately compare actual investment outcomes.
| Underlier Price Return | Underlier 2-Year Return with 1.5% Dividend | 1st Place | 2nd Place | 3rd Place | 4th Place | 5th Place |
|---|---|---|---|---|---|---|
| 50% | 53% | Uncapped | Underlier | Capped | Contingent | Fixed |
| 40% | 43% | Uncapped | Underlier | Capped | Contingent | Fixed |
| 30% | 33% | Underlier and Uncapped | Capped | Contingent | Fixed | |
| 20% | 23% | Capped | Underlier | Uncapped | Contingent | Fixed |
| 10% | 13% | Capped | Contingent | Fixed | Underlier | Uncapped |
| 0% | 3% | Contingent | Fixed | Underlier | Uncapped and Capped | |
| -10% | -7% | Contingent | Fixed | Uncapped and Capped | Underlier | |
| -20% | -17% | Contingent | Fixed | Uncapped and Capped | Underlier | |
| -30% | -27% | Fixed | Contingent | Underlier | Uncapped and Capped | |
| -40% | -37% | Fixed | Contingent | Underlier | Uncapped and Capped | |
| -50% | -47% | Fixed | Contingent | Underlier | Uncapped and Capped | |
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
One key finding is that the dividend is more impactful than the Growth Note’s multiplier for smaller positive returns. This is because the 1.5% dividend over two years generates a larger return than the Uncapped Growth Note’s 110% participation.
For example, when the Underlier posts a 10% price return, the Uncapped Growth Note and Underlier returns are as follow:
| Underlier Price Return | Asset to be Modified | Modification | Total Return |
|---|---|---|---|
| 10% | Underlier | Dividend +3% | 13% |
| Uncapped Growth Note | Multiplier 110% | 11% |
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
Investors often face a decision between purchasing the Underlier or a Structured Note linked to the Underlier. Therefore, it is crucial to factor in dividends to generate a genuinely net-of-everything comparison between the Note and Underlier.
Magnitude of Performance Differences, Underlier Dividend Included
The numbers in the following table are used to populate the previous leaderboard, which demonstrates the impact of the dividend adjusting the net performance of the Underlier upward.
| Underlier Price Return | Underlier 2-Year Return with 1.5% Dividend | Uncapped Growth vs Underlier | Capped Growth vs Underlier | Contingent Income vs Underlier | Fixed Income vs Underlier |
|---|---|---|---|---|---|
| 50% | 53% | 2% | -23% | -35% | -37% |
| 40% | 43% | 1% | -13% | -25% | -27% |
| 30% | 33% | 0% | -3% | -15% | -17% |
| 20% | 23% | -1% | 7% | -5% | -7% |
| 10% | 13% | -2% | 7% | 6% | 3% |
| 0% | 3% | -3% | -3% | 16% | 13% |
| -10% | -7% | 7% | 7% | 26% | 23% |
| -20% | -17% | 17% | 17% | 36% | 33% |
| -30% | -27% | -3% | -3% | 12% | 13% |
| -40% | -37% | -3% | -3% | 8% | 13% |
| -50% | -47% | -3% | -3% | 4% | 13% |
Source: Halo Investing, as of May 2023. Examples are hypothetical and for illustrative purposes only. The information does not constitute a recommendation from Halo Investing. There is no guarantee that these objectives will be met.
Guidelines to Implementation
This analysis demonstrates the importance of choosing the right type of Structured Note payoff. For example, selecting a Fixed Income Note at the outset of a raging bull market can lead to a disappointing lag in performance. On the other hand, a Fixed Income Note could be an investor’s saving grace during a bear market. These are just two examples of the importance of market cycle when choosing a Structured Note’s payoff type.
Investors cannot accurately navigate the market cycle with absolute certainty. However, there are a handful of elements that can increase the probability of success in determining the market cycle:
- Leading Economic Indicators — a diverse basket of data points that typically precede the economic cycle.
- The Yield Curve — the shape and steepness is a historically strong indicator.
- The Fed Model — the earnings yield for stocks versus the interest yield on 10-year Treasury bonds can signal equity-risk complacency.
- The Buffet Indicator — the value of the stock market relative to the output of the economy can signal if stocks are broadly overvalued.
- The Shiller PE Ratio — the valuation multiple of the stock market, combined with long-term earnings and inflation, can signal how expensive the market is.
These metrics should not be used individually, in a vacuum. Rather, they should be measured alongside one another in a mosaic to determine an objective rationale for the current state of the market cycle.
Conclusion
It’s clear that Structured Notes have many applications. For the most significant upside, Uncapped Growth Notes have the potential to outperform while providing protection on the downside. Capped Growth Notes are unique in their potential to outperform greatly when the Underlier has muted positive returns. Contingent Income Notes can provide a strong income stream in sideways to moderately negative markets. Finally, Fixed Income Notes show the greatest potential to manage downside risk, regardless of how deep the losses go.
Portfolio managers can apply the different functions of Structured Notes to:
- Gain a significant competitive advantage
- Lever up and down risk efficiently
- Manage clients’ emotions
- Dampen risk within the asset class rather than relying on diversification or low-volatility active managers
- Decrease the frequency and severity of negative returns
Halo Investing exists to streamline the analysis, transaction, and management of these dynamic investment vehicles. Call your financial advisor or Halo representative to learn more today!
Note that indicative quotes are substantially lower than auction quotes the vast majority of the time, so real terms would likely be higher than the example indicative quotes.
