Bonds for the Equity Investor

Bonds for a betting man

Have you ever placed a bet? You agree to pay a certain amount to your friend/casino if a certain condition is met. For example, you may have bet that the Patriots were going to win the NFL in 2017. Or that Chelsea would have won the EPL in 2016. If you are tired of losing money to sports betting, the recent rise in volatility in financial markets has made “making bets” more attractive. In recent weeks, large cap investment grade rated banks have started issuing fixed income instruments with very high interest rates. However, the payment of the coupons is contingent on the fulfilment of specific conditions. Similarly, the repayment of principal is also linked to an external condition. Let’s take a look at how these instruments work:

A large U.K. Bank could issue a note with the following conditions:

• You will receive income of 8.7% each year, if the S&P 500 does not fall by more than 30%. The index level of the S&P 500 is recorded on the issue date of the note. It is called the “initial index level”. On a quarterly basis, the issuer will check the level of the S&P 500 and compare it to the initial level. Think of this quarterly date as the day of the “football match” or the day on which the outcome of your bet will be determined. If, on the “observation date”, the S&P 500 index level is 70% or more of its initial level, you will receive income that's equal to 8.7% p.a. of your principal. If however, your team loses the football match, you don’t receive any money. Similarly, if the S&P 500 falls by more than 30% on the “observation date” - you will NOT receive an interest payment.
• You will receive 100% of your principal investment as long as the S&P 500 does not fall by more than 50%. Should the index fall by more than 50%, your principal will be exposed to the full downside of the index. For example, if the index falls by 60%, you would receive $400 for every $1000 invested. If however the index remains at or above the initial level, the investor will receive his full principal at maturity.

There are many variations to this structure. It's possible that the payment of coupons and principal could be linked to the performance of more than one index, or on an entirely different reference asset (e.g. the price of oil or apple stock).

These notes allow investors to get much higher returns from a high quality credit. A “plain vanilla” 7 year bond from the same large U.K. bank currently offers investors a yield of approximately 3.6%. Investors receive an extra 5.1% to compensate them for the risks tied to the equity market performance.

Credit Risk

Investors must be aware of the difference in buying a note issued by a local institution and a note issued by an investment grade rated bank in the US or UK. If these notes are issued by local financial institutions, they will carry the credit and country risk inherent in the local environment. However, investors have the ability to access similarly structured notes backed by large banks such as Barclays, Morgan Stanley and Goldman Sachs for much lower levels of credit risk and at much higher coupons.

Liquidity and Duration Risk

Structured notes are not usually widely traded and can be fairly illiquid. Investors should be prepared to hold the note until maturity or accept a price cut if they would like to exit before maturity. The tenor or duration of these notes is also very important. Investors should aim to minimize the tenor of the notes and keep the tenor as short as possible in the context of the current environment. As interest rates and volatility rise, the issuance of structured notes will increase and the terms will become more attractive. Once this happens, investors could extend the duration of the notes they purchase and possibly use modest amounts of leverage to enhance their returns.

Marian Ross is an Assistant Vice President of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm