Traditionally the diversification offered by balancing equities and bonds in a well-structured portfolio was enough to ride out market volatility; with the one offsetting the other during tough times. But in an uncertain environment, in which these polar opposites are becoming decidedly more correlated, there is a need for a new hybrid asset class. Structured notes are filling the void.
More than five years ago Carrick Wealth began offering a new portfolio construction building block: income notes. A lower-risk subset of the relatively new structured notes category.
While structured products date back to the 1990s, where they emerged out of the UK, these pre-packaged debt securities were initially the preserve of institutions and high-net-worth investors. Only fairly recently have specialist firms made them more widely available, driving up global demand to around US$2 trillion in assets under management.
What’s the attraction?
The appeal of structured notes has everything to do with low to negative interest rates globally, coupled with unprecedented levels of market volatility, as well as declining dividend payouts. Investors are facing low yields on fixed-rate bonds and no capital protection in the equity space. Risk tolerance is low.
Anthony Palmer, Group Commercial Director at Carrick Wealth, explains that structured notes offer a “nice hybrid, tucked between equities and bonds, which offers the best of both worlds from a performance perspective and a risk-mitigation element”. They comprise a bond element together with an embedded derivative and, typically, fall into two categories: growth notes (which participate in upside returns) and income notes.
Lower-risk income notes offer a conditional payment – or coupon – over the life of the note and have in-built downside protection.
“They work very well with traditional assets,” explains Palmer, adding that Carrick Wealth is conservative in their use of income notes. “They play a very specific role in our portfolios. We are not structuring notes for massive outperformance, we just want that steady sort of 5% sterling, 6% in US dollars range to come into our client portfolios.”
Ultimately the aim is to create more certainty around returns, particularly during times of market unpredictability.
Palmer explains that in March 2020, amidst the COVID-19 sell-off, Carrick Wealth had 56 notes in circulation and 49 paid all their coupons. “Six missed their coupon payout due to the FTSE 100 breaching its barrier,” he explains, noting that by the next quarter those six ‘laggard’ notes had paid out that quarter’s coupon and caught up the previous quarter’s payment due to the memory feature.
“They behaved and performed exactly as they were designed to – benefitting from the product’s in-built ‘memory feature’,” explains Palmer.
The inner workings of Structured Notes
Understanding this memory feature, along with terms like ‘barrier’ and ‘coupon’, is an important first step in understanding structured notes. These essentials can be simply explained as follows:
- Coupon: Interest which is paid out on a quarterly, semi-annual or annual basis.
- Maturity: Duration can range from six months to over a decade. Carrick Wealth works with six-year notes.
- Developed market reference indices: Since the payment of the coupon depends on the stability of an index, Carrick only uses developed market indices, specifically the likes of the FTSE100, Euro Stoxx50, Nikkei and S&P 500.
- Issuer: Structured notes are issued by major financial institutions. The creditworthiness of the deposit holder is essential.
- Barrier: At predetermined intervals the issuing bank determines if any of the chosen indices have dropped by more than a predetermined amount such as 30%. If not, investors receive their coupon. However, if one index had dropped below the 30% barrier then the coupon will not be paid.
- Memory feature: This risk mitigant feature kicks in if a coupon payment is missed due to a barrier breach. It means that if a coupon is missed it can be made up again at a future observation date when the indices are back within their respective barriers.
- Back testing: Carrick Wealth runs around 2 500 tests and simulations to highlight the potential for performance across a range of market conditions, outlooks and variables.
Simple and Liquid
One you’ve made friends with the jargon, these products are both remarkably simple and liquid, explains Clive Moore, MD of niche structured products experts iDAD. “Returns across different scenarios are clear and there are no lock-ins. All products are liquid and are priced every day, although ideally the product is designed to be held for the full term.”
There is also “no Harry Potter magic” when it comes to fees, adds Moore, explaining that costs are lower than that of a traditional fund at “around 1%-1.25% over six years compared with 0.75%-1% per annum for a fund”.
Carrick Wealth works exclusivity on structured notes with UK-based iDAD, bringing two structured notes to market every month. “Each structured note that we bring is in both pound sterling and US dollars,” explains Palmer.
“There can be a number of pitfalls with notes, so you have to be very careful to build the notes properly – from senior debt to the right barriers, issuers and indices,” says Palmer. “Structured notes span the risk spectrum and range from low risk to very high-risk notes linked to single name stocks. Carrick only use lower risk notes. Ultimately, we are looking for stability, increased certainty of income and levels of downside protection, which is key in terms of risk and which offers appropriate returns. Risk is at the forefront of everything we do.”