Higher interest rates help revive bid on principal-protected notes; sales up more than 100%

By Emma Trincal

New York, April 12 – Bond yields moving higher have boosted issuance of the most conservative structured product in the market this year.

Principal-protected equity-linked notes providing up to 90% to 100% of principal guarantee accounted to $2.96 billion through April 5 in 175 deals, according to data compiled by Prospect News.

The notional for this product represented 12% of the $24.35 billion sold in equity-linked products, which consist of notes tied to single stocks, baskets of stocks and equity indexes, according to Prospect News’ methodology.

Principal-protected notes accounted to 10.4% of this year’s total across all asset classes, which is $28.33 billion.

Twice more

Principal-protected equity-linked notes have more than doubled in volume from $1.41 billion printed in 542 deals during the same period last year.

The average principal-protected note has a 3.5-year tenor, according to the data. Back to last year’s first quarter, the three-year Treasury yield fell from $4.09% to 3.89%. This year it rose 80 basis points to 4.8% from 4%.

Zero-coupon

The growth of those sales is driven by rising interest rates, according to market participants. It makes logical sense from a pricing standpoint, they said. Higher rates lower the cost of structuring principal-protected products by virtue of their construction. Those notes combine a zero-coupon bond with long call options. The zero maturing at par allows for the return of principal. When interest rates rise, the discount of the zero-coupon bond will expand, providing more purchasing power to buy the options.

Other wrappers

Notional growth for those products does not even include the higher demand for market-linked certificates of deposits, which, under some limits, offer protection against both market and credit risk. Prospect News only compiles structured notes registered with the Securities and Exchange Commission, which naturally excludes market-linked CDs.

Ordinary income

Principal-protected notes offer a floor against losses typically guaranteeing 90% to 100% of principal. The protection in place works almost the opposite way of buffers, which protect the initial loss to a small extent but not once the price declines further.

These differences in protection have negative tax implications for investors in principal-protected products as they must pay ordinary income tax each year on so-called “phantom income,” which has not been collected.

Some advisers also object to their cost and to their limitations in terms of reduced upside participation, caps and loss of dividends over longer holding periods.

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