Structured Investments in Action Part III: Trade-Offs in Pursuit of Enhanced Income
Structured investments have evolved a lot over the last few decades, with an increase in flexible ways to tailor a portfolio to the unique situation and needs of an investor looking for either growth or income.
Income-oriented structured investments are typically used to pursue the opportunity for enhanced coupon payments versus more traditional investments like bonds. Unlinked fixed income instruments, the coupon payments on market linked income notes are based on the performance of an “underlier” such as an equity index, a basket of indices, or even a single stock.
While the structured investment market is best known for its multitude of risk-managed growth strategies, demand for market linked income notes has increased dramatically in recent years, driven in part by a lack of alternatives in the fixed income markets. So, what do income solutions look like in the structured investment world? A high-level definition can shed some light:
- generating yield is the goal
- designed for an investor looking to earn income/yield on their assets; generally characterized by the potential to earn coupon payments during the life of the investment
- tied to the return of an underlier such as an equity index, a basket of indices, or a stock
- most offer contingent downside protection, but some may provide partial or full protection (for more information on the various types of protection, see our latest article on that topic here)
- coupons are generally dependent on the underlier’s performance, so income may not be consistent
The appeal of market linked income notes is that they typically offer high-single digit to double-digit coupons, depending on factors such as the volatility of the underlier and its dividend yield. This can be attractive to income-seeking investors. But, as investors look to the structured investment market for these potentially enhanced coupons, it is important to be aware of the trade-offs involved with using equity exposure to try to generate yield.
Market linked income notes have certain unique considerations, and investors should:
- understand that, unlike bonds, some income generating structured investments may carry risk of significant loss and/or risk of receiving no coupon payments at all
- be aware that they are not eligible to receive dividends on the underlier; they forego their dividend in exchange for the potential coupon
- understand whether the investment has a call feature and if it does, what catalysts drive its callability
- understand that market linked income notes are buy-and-hold investments—there is no guaranteed secondary market and while issuers have historically bought back structured investments, they are under no legal obligation to do so
- be comfortable with the creditworthiness of the issuer since payments made by structured investments are subject to the credit risk of the issuer
One of the more popular income solutions in the structured investment market in recent years has been callable market linked income notes with contingent coupons. These notes 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. They come with different types of call features, and many different levels of downside protection.
For more information on how they are used and how they work, read our article, “A Non-Traditional Approach to Generating Yield” here.
Structured investments come in a wide variety with different terms and conditions. There’s one for almost any market outlook or investment goal, giving investors the chance to stay in the market, pursue income enhancement, and choose how much protection they need to feel comfortable.
When considering any structured investment, understand the type of protection it offers as well as its pay-out potential by working with a qualified financial professional and carefully reviewing the offering documents before investing.
To learn more about how risk-managed and alternative solutions can be used within a diversified portfolio, visit simon.io/engage.
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