What fixed income investors do in a rising interest rate environment?

The Sterling Report

Mildred Moss

Saturday, August 16, 2014

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Interest rates in the US and the UK are set to rise -- not right now, but sometime soon. What is an investor who likes the security and income of bonds to do? Today we will take a look at structured notes --a fixed-income instrument that is popular in times of rising interest rates.

What is a structured note?

The issuance of structured notes is rising rapidly, both locally and internationally. The sale of notes tied to US interest rates surged to a three-year high in July, according to Bloomberg data. A structured note pays interest (and principal) only if certain pre-established conditions exist or manifest themselves. These conditions are wide and varied. For some simple examples, please see the list below:

1. A note could pay interest of nine per cent as long as Facebook stock does not fall by more than 30 per cent in any one "observation period".

2. A note could pay interest of 7.5 per cent as long as both the Russell 2000 and the Euro Stoxx 50 does not fall by more than 25 per cent in any one "observation period".

3. A note could pay two times the gains on the S&P 500 index (and zero per cent otherwise)

As you can see, these notes are a great way for equity investors to participate in the market without risking a complete loss of principal.

Structured notes can also be customized for institutional and individual investors. These notes allow investors to "bet on or against" a particular trend or occurrence. Most recently, investors have been betting on the direction of US interest rates and spreads. For example:

1. A note could pay interest of five per cent as long as one month Libor remains between zero per cent and four per cent .

2. A note could pay interest of 10 per cent fixed for year one. Thereafter the note could attract a coupon equal to six times the difference between the 30-year and the five year US Treasuries. (The difference between the 30-year and five year will contract as interest rates rise.)

During this past week, tensions in the Middle East fuelled the sale of notes tied to the price of crude oil.

The payment of interest (and sometimes principal) is tied to the fulfilment of the conditions specified. For principal-protected notes, the issuer promises to repay principal to the investor no matter what. The rate of interest is normally lower for principal-protected notes.

Credit risk

Local investors have been participating in structured notes linked to global currency and equity index markets. These notes are issued by local financial institutions and therefore 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 similar returns and much lower levels of credit risk and at much higher coupons. 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.

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 minimise 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 Business Development 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




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