Investors new to structured notes often say, “this looks too good to be true.” Since structured notes offer protection and upside participation, the question we often get is, “what’s the catch?”
The common answer is that the investor is losing out on dividend payments of the underlying asset.
When a structured note is linked to a stock, or basket of stocks, an investor is effectively giving up dividend payments since the underlying security isn’t actually purchased.
But are you really giving up a dividend?
Income-oriented structured notes are designed to give investors regular coupon payments (similar to a dividend) over the life of the note.
Investors who purchase these Income Notes receive a fixed coupon payment as long as the underlying assets’ price level isn’t below the protection level at the date of the coupon payment.
Additionally, at the end of the note’s term investors receive their original invested principal back unless the underlying asset price is below the protection level. This is when potential loss on principal takes effect depending if hard or soft protection is utilized. Even at maturity and if any principal is lost, the investor still keeps the coupon payments they’ve collected over the term of the note.
Income notes can offer investors a relatively high amount of income over the period of the note. When interest rates are at record lows and when strong companies are decreasing or eliminating dividend payments to conserve cash, income notes can lock in a level of protection against volatility and dividend cuts.
How An Income Note Works
When you purchase an Income Note, you are effectively selling put options. This means the volatility of these options is used to determine the size of the coupon paid.
The higher the expected dividend of a security, the higher the value of the Put options you sell.
Even with recent price disruptions, many “Blue Chip” companies still have high expected dividend yields. Add in record setting volatility levels, Puts are priced extremely well, resulting in increased yields on Income Notes.
There is a direct correlation between volatility, dividend yields and the resulting yields on Income Notes.
In other words, this is an opportune time to look at Income Note returns.
Income Opportunity with Market Movement
Since an Income Note can be implemented in any market environment, we will look at how this investment thesis plays out through the underlying assets in three potential market scenarios:
Scenario 1: Flat Market
In the first scenario, the market moves sideways and is systemic in the medium to long term.
Many companies may be forced to cut their dividends to maintain business operations. The stock price should stabilize while the Income Note remains attractive with its enhanced yield along with some protection after a dividend cut from a further market downturn.
Purchasing an Income Structured Note with guaranteed coupons (subject to the issuer’s ability to pay) will allow the investor to receive an attractive fixed annual return while offering a level of downside principal protection on the underlying stock(s).
Under this scenario, the investor ultimately locks in what can be an attractive return. An income note in this kind of market environment takes advantage of both the high dividend prior to the company cutting its dividend to purchase an attractively priced note, plus locking in the abnormally high volatility in the form of more protection.
Scenario 2: Further Decline
In the event the underlying stock does decline and cause principal loss, the income generated from the Note should cause the investment to outperform the underlying security.
This leaves your client with more capital to invest at lower market levels in comparison to investing in the underlying assets.
For example, if at maturity, the Underlying is down by more than the protection amount, the investor’s principal will be fully exposed to the loss of the underlying on a price basis, however, the investor would be receiving their fixed coupon all along the way, helping offset those losses.
While the investor has lost a portion of their principal, they can take what’s left plus the coupons they’ve collected, and reinvest it in a Growth Structured Note offering enhanced upside on the Underlying’s price return, “playing the bounce.”
Scenario 3: Quick Recovery
In scenario three, the stock recovers rather quickly from recent market drops.
Let’s say the stock appreciates 30% from today’s levels in the next year (a potential maturity date of the note). This is where the opportunity cost comes in with Income Structured Notes.
Remember, Income Structured Notes with guaranteed coupons pay a fixed annual return (in the form of quarterly coupons). The investor receives no more and no less than the fixed return during the life of the Note.
In this example, the investor would have received a predetermined annual return when purchasing the note.
Theoretically, the holder of the note would underperform the 30% return had they owned the stock outright.
With this in mind, the investor may still find the coupon payments they did receive while having the downside protection compelling, in the event the underlying stock falls further.
Investing with Income Notes
Income Notes can add flexible income and protection options to portfolios.
Investors can use Structured Notes to tactically take advantage of the high dividend rates many companies are currently paying, given the current market pullback.
This is because options that are sold account for the company’s current dividend yield. Coupled with the abnormally high volatility we are witnessing, Income Structured Notes may be a suitable way to lock in higher than average fixed returns while offering a level of investment protection from further price declines.
While an Income Note pays out a coupon payment like a bond, investors should bucket an Income Note just as they would the underlying asset the note is linked.
This means if the underlying was a broad US equity index, or specific stock, the note should be classified as an equity in your portfolio allocation. The primary reason being the investor is taking equity risk on the downside.
By substituting a portion of an equity allocation to an income note it can provide a level of income on top of downside protection.
Reach out to your Halo representative or firstname.lastname@example.org today and get a demo of the Halo Investing platform to see current Income Note opportunities.