What's Ahead:
- Structured note's flexibility can shine during periods of financial and economic uncertainty.
- For example, compelling yields and short duration can make notes a good antidote to a hawkish Fed.
- Strategies such as laddering notes can offset interest rate sensitivity.
In early 2022, inflation as measured by the Consumer Price Index (CPI), reached levels not seen since the early 1980s. Not surprisingly, interest rates have been on the rise. Against a backdrop of uncertainty, this guide will help investors make more confident decisions when allocating to structured notes.
Inflation and Interest Rates: Two Birds of a Feather?
Inflation and interest rates often move together. The chart below illustrates this relationship. While rates and inflation don’t always move perfectly in tandem, their correlation is noticeable.
These are just two variables in a highly complex market. But, if history is any guide, as inflation moves higher, rates could follow. The U.S. Federal Reserve finally began its rate-hiking cycle on March 16, 2022. The Federal Open Market Committee (FOMC) increased its short-term policy rate by a quarter point. Through early 2023, the possibility of more rate hikes remains elevated.
Lessons Learned: Asset Class History
Some tactics to fight inflation could include:
- Shortening bond duration, potentially decreasing the negative price impact that would come with higher interest rates.
- Allocating to commodities, since a weaker currency may make the cost of raw materials increase. Historically, higher bond yields correspond with higher commodity prices during inflationary periods according to some market studies.
- Allocating to real assets such as infrastructure or real estate, which have historically outperformed traditional asset classes during high inflation environments.
Sector History: A Helpful Guide
Sector positioning can also be an effective inflation-fighting move. Historical sector returns are a potential guide for which sectors to avoid or target throughout different interest rate regimes. Over a 20-year period across multiple market cycles and interest rate regimes, Materials and Energy were the best performers with rising rates while Communications and Utilities lagged.
Structured Notes
As an alternative, investors are increasingly turning to structured notes. Historically, structured notes have had high fixed costs which reduced accessibility. Technology, competition, and operational innovations have increased access materially over the last decade, with more than 30% year-over-year growth in both 2020 and 2021.
Component 1: Reference Asset
A structured note can be used to help protect investors from the risk of rising inflation. Since real estate and commodities tend to outperform when inflation fears rise, a reference asset tied to these asset classes could make sense. The reference asset is what the structured note is tied to. Think of the reference asset as the “underlying asset.” The performance of a structured note generally tracks the performance of an underlying asset- an index, stock, group of stocks, commodity, or foreign currency- over the maturity period.
The reference asset’s performance is typically modified for both downside risk and upside potential when determining a structured note’s performance. This results in a structured note potentially having more precise risk exposure to a reference asset than if the asset were held in more traditional ways.
Advisors can drill down to the sector level to mitigate inflation risks. In the past, higher interest rate environments have benefited the Materials and Energy sectors. Energy and Materials stocks could be used within a growth structured note (the note’s performance can be tied to the lower-performing underlier).
Indicative pricing on Feb. 23, 2022, suggests an annualized yield of 14.27% is attainable on an income note tied to the Energy and Materials sectors. Of course, the investor must hold the note through maturity and certain market conditions must happen—the type of note’s interest payments are contingent upon the performance of the reference asset.
During the life of the note, the potential income return follows a binary scenario regarding the coupon protection level:
At maturity in 36 months, there are two scenarios for the return of the initial investment principal:
The reference asset can be a single asset, weighted basket, or a “worst-of” basket. The majority of reference asset structures are single assets and highly-correlated assets in a “worst-of” approach.
Component 2: Term To Maturity
A note’s term to maturity is generally managed on a case-by-case basis.
Factors may include:
- Investor liquidity needs and time horizon
- Other assets and exposures within an investor’s portfolio
- Tax considerations
- Expectations for inflation persistence
- Reference asset(s)
- Other unique investor circumstances
For investors creating a strategic exposure to combat inflation, laddering structured notes is a potential solution. This technique sets the maturity dates of multiple notes to occur over a period of time, rather than all at once. This may decrease the average time until the next maturity date, potentially assisting with liquidity needs.
In the example below, an investor could split a structured note exposure across four notes, all purchased simultaneously. By scheduling the notes to mature in 24, 30, 36, and 42 months, the notes have a maturity date every six months. At each note’s maturity, reinvesting the note’s potential proceeds into a new 24-month note may result in an exposure that could possibly be maintained into perpetuity.
Component 3: Protection
Protection is a key factor in determining how the investment capital is at risk, as well as the upside potential a note features. There are two types of protection: soft (barrier) and hard (buffer).
Return scenarios at maturity include:
In a rising interest rate environment, more protection may be useful. Inflation can cause economic difficulties, and often leads to tightening monetary policy. This scenario could cause asset prices to decline if investor sentiment or growing corporate earnings do not offset structural changes. For reference assets that have the propensity to decline significantly, hard protection may be preferred to cover a more comprehensive set of downside scenarios.
Component 4: Payoff
Growth and income notes are the two main payoff structures:
Growth and income notes can be used to fit many market theses an advisor might have. Those concerned about falling stock prices and a highly-volatile market might consider income notes. More aggressive outlooks could warrant the use of growth notes to capture market upside. Advisors can work with the team at Halo to help select the right products based on the advisor’s desires.
Call and Reinvestment Risk
When interest rates fall, issuers are more likely to call their bonds. A call provision allows the issuer, at its discretion, to redeem the note before it matures at par value or par value plus a call premium. If the issuer “calls” the structured note, investors may not be able to reinvest their money at the same rate of return provided by the structured note that the issuer redeemed.
The call provision can work against investors when market rates drop since reinvestment risk is introduced, whereby an investor may have to reinvest proceeds at lower rates. During rising interest rate environments, however, reinvestment risk can be positive since the investor might be able to reinvest in products with higher interest rates.
Callable income notes can have multiple benefits:
- When the note is called, it can secure a positive return for the note. The full principal can be paid back and at least one coupon payment is made.
- Callable notes may have a higher yield than non-callable notes.
- In a rising rate environment, investors may be able to reinvest the called note proceeds into a similar note with a higher yield than the original note.
Callable income notes have reinvestment risk. There is no certainty that a called note can be reinvested at a similar rate. Even if interest rates rise, other factors like volatility levels and the shape of the yield curve can lead to a relatively lower yield than previously available.
Structured Notes’ Market Value Impact From Interest Rate Changes
As noted above, the largest portion of a structured note is a zero-coupon bond. Nearly all fixed-rate bonds have interest rate risk, also known as duration risk. The assets within structured notes are no different. Structured note valuation is generally marked to market daily, responding to changes in:
It is difficult to find exact numbers for bond valuation. However, we can use simple measures for a basic understanding of how an interest rate change may impact a structured note. The standard rules still apply: interest rates have an inverse relationship to bond prices. When interest rates go up, bond prices usually go down.
In a hypothetical example, the zero-coupon bond within a structured note has a two-year duration and comprises 80% of the structured note’s weight. All other variables are held constant.
At 80%, the price impact on the structured note would roughly be:
As we can see, an increase in interest rates may have a negative impact on the price of the structured note. This is a factor during the life of the note, before maturity.
Structured notes are typically designed to mature at par value. Therefore, a change in interest rates may not be a direct factor for a structured note’s price at maturity. Indirectly, changes in interest rates can impact other areas of a structured note at maturity, with the primary driver being the performance of the reference asset.
Structured Note Ladder as a Fixed Income Alternative
Given that most corporate bonds trade over-the-counter (OTC) rather than on an exchange, many investors prefer to buy bond funds for fixed income exposures. This can improve liquidity, but may present challenges elsewhere. A bond fund will have a constant rotation of bonds entering and leaving to manage buy and sell orders. This means interest rate sensitivity is a critical component of a bond fund’s performance. Simply put: If interest rates go up and investors sell, these investors will be negatively impacted from a bond price perspective due to the increased interest rates.
A benefit that bond funds see during periods of rising rates is an increase in yield. When new bonds enter a fund at a higher interest rate than their predecessors, they may boost the portfolio’s overall yield. However, this will most likely come at the expense of price depreciation. Bond funds that have a duration greater than one year may see a net loss during periods of rising rates.
Here’s a hypothetical example, holding all else constant:
Laddering structured notes can help offset the risk of rising market interest rates. At maturity, notes are replaced with higher-income notes. A risk, however, is that market conditions might not allow for reinvestment. Changes in volatility can also impact a structured note ladder’s yield profile.
Please see our Halo Disclaimer for other important disclosures.
