A Non-Traditional Approach to Generating Yield
Generating yield is challenging in this environment of historically low rates, yet clients still seek it. Here’s one way to help meet that goal.
Callable Market Linked Income Notes are a type of structured investment designed to offer higher income potential than traditional debt instruments. By tying contingent coupons to the performance of a market underlier, whether an equity index, stock, commodity, or other reference asset, contingent coupons in a Callable Market Linked Income Note are what enable these notes to generate typically higher yields than corporate bond or treasury markets, subject to certain additional risks that we’ll discuss in this article.
Bonds aren't providing the same level of income as they did prior to the drop in interest rates we saw earlier in 2020. Increasing yield in the bond market typically requires a longer duration or lower credit rating; as an alternative, Callable Market Linked Income Notes offer access to higher potential yield in the form of contingent market-linked coupons.
How do Callable Market Linked Income Notes work to provide income?
Callable Market Linked Income Notes with contingent coupons can provide income, paid monthly, quarterly, semiannually, or annually, as long as the underlier remains at or above a certain threshold, which is called the coupon contingency level. If the underlier falls below the coupon contingency level on any of the observation dates, the periodic payments stop until the underlier rises above the threshold on a future observation date.
Callable Market Linked Income Notes can include one of two call features. With the example below, we will look at a Callable Market Linked Income Note that would be redeemed early based on the performance of the underlier. This type of call feature is called “autocall” because the note is automatically redeemed if the underlier is at or above a certain level on observation dates, as specified in the offering document.
Let's consider a Callable Market Linked Income Note with the following terms:
This note pays a semiannual coupon of 10% p.a. as long as the SPX is at or above 70% of its initial level on the semiannual observation dates. It also has an autocall feature, which means that the note will be automatically redeemed early for par if the SPX is at or above 100% of its initial level on any call observation date, noting that call observation dates take place semiannually starting one year after the trade date (the “non-call period”). Lastly, this note has protection in the form of a 30% Barrier. This means the holder is not exposed to principal losses if the underlier stays at or above the barrier protection level, which is 70% of its initial level, at the end of the term; however, if the underlier is down more than 30%, the protection disappears entirely, and losses are 1:1 from SPX’s initial level.
What is the Callable Market Linked Income Notes payoff under different hypothetical market outcomes?
Let's look at three examples of hypothetical market scenarios to understand how the above Callable Market Linked Income Note would behave in each. These are not representative of actual market scenarios, nor do they represent all possible market scenarios.
1. Index Moves Higher from Trade Date:
2. Index Remains Rangebound Between Coupon Contingency Level and Call Contingency Level:
3. Index Moves Lower from Trade Date:
When to Consider Callable Market Linked Income Notes:
For clients looking to build more income potential into their portfolio, or clients seeking to meet specific income goals, Callable Market Linked Income Notes may be a welcome consideration. While Callable Market Linked Income Notes offer the possibility for higher yield in the form of contingent coupons, it should be noted that they also carry a greater degree of risk that must be weighed, including full exposure of principal to losses, issuer credit risk, and liquidity risk. Take note of the following benefits and considerations:
- Income Potential: Callable Market Linked Income Notes can deliver higher income potential than certain other income producing investments, like corporate bonds or treasuries. Note that the income is subject to certain contingencies and is not guaranteed.
- Downside Protection: Callable Market Linked Income Notes offer more protection than a direct investment in the underlier itself, although less protection than traditional debt instruments.
- Contingent Income: Callable Market Linked Income Notes can stop paying income or be called based on the performance of the underlier. It is possible that zero coupons are received during the life of the trade.
- Downside Exposure: Unlike corporate bonds or treasuries, Callable Market Linked Income Notes have downside exposure, which expose principal to risk of loss.
- Credit Risk: Callable Market Linked Income Notes holders are exposed to the credit risk of the issuer and must be comfortable with the issuer’s creditworthiness for the life of the investment.
- Liquidity and Statement Value: Callable Market Linked Income Notes are buy and hold investments, which means that investors must be comfortable holding the note until maturity in order to receive any return of principal, and there is no guaranteed secondary market. Issuing firms may offer to buy back a structured investment before maturity, typically at a discount to statement value, however they are under no legal obligation to do so.
- Call Feature: Callable Market Linked Income Notes can be called before maturity based on the performance of the underlier, as specified in the offering document. It is possible the trade does not last for the full length of the stated term. This introduces reinvestment risk to the extent a trade is called early and similar reinvestment alternatives are not available.
Investments frequently utilized to generate yield include preferred stock, corporate bonds, stocks with high dividend yields, and municipal bonds. Each type of investment offers a different risk and reward profile.
When considering which type of investment is best for a given scenario, it’s important to ask the following:
Does the investment vehicle deliver adequate reward for its associated risk?
The nature of this question is situation-specific and must take into account a client’s unique investment objectives, risk tolerance, and additional factors. To the extent the answer is “no” for current holdings, consider the alternative risk and reward profile available in the form of Callable Market Linked Income Notes.
Are you a financial advisor? If your firm provides access to SIMON, you can view and filter for the latest Callable Market Linked Income Notes available in SIMON’s Marketplace on simonmarkets.com. If you do not have access to simonmarkets.com and would like to learn more, connect with our team by emailing us at email@example.com and request a demo with one of our Platform Specialists.
You can also learn more about structured investments and how they can help keep clients invested over the long term with articles and videos available on simon.io/engage.
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