Welcome to the third part in our structured investment educational series, and thanks for all of the positive feedback so far. We’ve been intrigued by some of the investments we’ve been asked to price up, with some excellent ideas coming from both investors and advisors.
In this post, we will look at Strategic Yielding Notes, which is a type of Fixed Coupon Note, and one of the more popular structured investments among institutional investors thanks to their fixed level of income combined with market linked elements.
Part 3 -Strategic Yielding Notes
In part three of this series, we look at Strategic Yielding Notes, which are a popular, equity linked structured investments that offers investors regular, unconditional, periodic coupon payments while providing exposure to an underlying stock (or basket of stocks). These instruments are designed to generate consistent income with a predefined level of risk.
In this post, we’ll explain how Strategic Yielding Notes are structured, their potential payoffs, and the pros and cons associated of investing in them.
Strategic Yielding Notes provide investors with unconditional, periodic fixed interest payments for the duration of the investment term, while the principal repayment is contingent on the performance of an underlying asset such as an equity index, a single stock, basket of stocks, or other tradable asset. Strategic Yielding Notes consist of two main components:
Fixed Coupon Component – This guarantees that investors receive unconditional, periodic interest payments, regardless of market conditions.
Derivative Component – A portion of the investment is linked to the performance of an underlying asset. Depending on the terms of the note, the principal repayment may be at risk if the asset’s performance declines beyond a certain point, known as the Strike.
How do Strategic Yielding Notes work?
When an investor buys a Strategic Yielding Note, they are buying an unconditional income stream that is paid regularly, with the principal investment being linked to an underlying asset. The performance of the underlying asset determines whether the investor receives their principal investment back at maturity, or shares in the underlying asset. Strategic Yielding Notes feature the following components;
Coupon Rate – The unconditional, fixed interest rate paid to investors at regular intervals.
Underlying Asset – The financial instrument that influences the principal repayment at maturity.
Strike Level – A predefined level that determines whether the principal is repaid in full or if investors may receive shares in one of the Underlying Assets.
Maturity Date – The date on which the investment expires, and final payments are made.
Strategic Yielding Note Example
For this theoretical example, we will create a Strategic Yielding Note linked to 4 of the largest mining companies on the ASX:
- Investment Amount: $100,000
- Underlying Assets: BHP, FMG, RIO, WDS
- Investment Term: 12 Months
- Fixed Coupon: 15% per annum
- Observation Frequency: 6 monthly
- Strike: 90%
In this example, the investor will receive a guaranteed level of income equal to 15% of the investment amount, which will be paid monthly regardless of how the Underlying Assets perform. For the investor to receive 100% of their principal investment amount back at Maturity, the Underlying Stocks must be trading higher than the Strike on the Maturity Date.
The Strike, represented as a percentage, of the Underlying Asset’s price on the Commencement Date of the investment. For example, if BHP is trading at $100 on the Commencement Date, its Strike would be $90.
Potential Outcomes
We have created some hypothetical outcomes below to demonstrate the potential returns an investor may receive by investing in the example investment on the terms outlined above.
Outcome 1: All Underlying Assets Perform Positively
If all 4 Underlying stocks are performing positively on the Observation Date, which is at the 6-month mark of the investment, the investment matures early and receives their principal investment back, plus any coupon payments received up until that point:
- Underlying Performance: BHP, FMG, RIO & WDS all Positive
- Coupon Payments: Principal of $100,000 x ((15% / 12) x 6) = $7,500
- Total Return: Principal of $100,000 + Coupon Payments of $7,500 = $107,500 (in 6 months)
In this example, the investor received their principal investment back, plus coupon payments of $7,500, or 7.5% in 6 months, which is an annualised return of 15%. Let’s look at the flow of funds:
Outcome 2: At least one Underlying Stock performs negatively, but is above the Strike at Maturity
If one of the Underlying Stocks performs negatively, but not lower than the Strike Price, the investor receives 15% in coupon payments, plus their principal investment back at Maturity:
- Underlying Performance: BHP, FMG & RIO Positive, WDS down 8%.
- Coupon Payments: Principal of $100,000 x 15% = $15,000
- Total Return: Principal of $100,000 + Coupon Payments $15,000 = $115,000
In this example, the investor received coupon payments equal to 15% of the investment amount, plus their principal investment back, a return of 15%. Below is the flow of funds for this outcome:
Outcome 3: Two Underlying Stocks perform negatively and lower than the Strike
In this outcome, investors still receive coupon payments of 15% over the investment term, but rather than receive their principal back as cash at Maturity, the principal is used to buy the worst performing underlying stock at its Strike:
- Underlying Performance: BHP, FMG Positive, RIO down 11% and WDS down 15%
- Coupon Payments: Principal of $100,000 x 15% = $15,000
- Total Return: Coupon Payments of $15,000 + (($100,000 worth BHP at 90%) – 5%) = $110,000
In this example, the investor received coupon payments equal to 15% of the investment amount, and their principal was used to buy BHP at its Strike price. The flow of funds shows that the investor is delivered shares in BHP:
As BHP is trading lower than the Strike, there is an additional paper loss of 5%, meaning that in this example, BHP would need to have fallen by 25% or more for the investor to suffer a net loss on this investment.
But as this investment is designed for investors that have a preference of being invested in the underlying asset(s), the investor purchased the worst performing underlying asset at a discount after receiving a fixed coupon over the term of the investment.
These examples show how Strategic Yielding Notes can be used to generate income when the investor is uncertain of how the underlying assets will perform. These type of products, like Fixed Coupon Notes, are popular with institutional investors as an alternate to other fixed interest products.
Benefits and Risks
Strategic Yielding Notes are often seen as an entry into the world of structured investments for both equity and income investors. They combine regular fixed income, like a bond or other fixed interest product, with a a link to equity or commodity markets with a discounted buying opportunity.
The risks with these products are clear; should one of the underlying assets perform extremely poorly,the investor could lose a significant amount of capital. Other risks that investors in these products must consider, is the credit rating of the issuer, and hedge counterparty. Investors should always ask about the credit rating of the hedge counterparty behind these trades; Anadara always quotes the hedge counterparties credit rating on our term sheets.
Summary
Strategic Yielding Notes have been created for investors that have a preference of being invested in the market, but fear that the market will pull back over the investment term. The guaranteed, fixed income payments provide the investor with regular income while they wait to see if the underlying asset(s) increase in value and mature early, or fall to a level that is lower than the strike, in which case, the investor buys the underlying asset at a discount, after receiving regular income payments.
These investments are highly customisable, and investors and advisors can choose from a broad range of underlying stocks, commodities, indices, or digital assets to link their investment to.
These enhanced yield products carry a level of risk that is higher than capital protected products, but lower than leveraged products, and are generally one of the more popular structured investments for institutional investors.
If you’d like to chat about structuring an investment linked to almost any tradable security from any of the major global exchanges, please get in touch with us to help you create a customised product for you.
As with any financial product, understanding the structure and potential payoff scenarios is key to making an informed decision. We highly recommend that investors speak to their professional adviser before choosing to invest in any of our products.
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