In the low to zero yielding environment of the past number of years, fixed income investors have been faced with the challenge to find yield alternatives without taking too much risk of principal. At times we have been using structured securities, based on companies with solid fundamentals, as part of portfolio’s fixed income allocation. We want to explain these structured securities in more detail and share our approach with you. While their construction can be complex and technical, we want to emphasize their application in our investment process.
While structured securities encompass a wide range of investments, up to now we are only using a certain type called reverse convertible notes with an underlying single stock. Technically this note consists of holding a zero-coupon bond and selling barrier put options (Down-and-In puts) on the underlying stock. The premium from selling these options delivers the majority of the coupon we are earning. Should the underlying stock decline more than the agreed percentage (the barrier) and not recover back to its initial price before maturity, we will own the stock or receive the equivalent value in cash as a result of the option contract.
The graphic below illustrates various potential price paths of the underlying stock and the resulting outcome of either return of principal or return of the underlying stock/ cash equivalent. In the case where the stock declines more than the allowed barrier (the option is “knocked in”), the amount of principal returned at maturity depends on the underlying stock price performance. Thus, the total return of the note moves in-line with the stock price should the barrier be reached.
We are taking equity risk with these reverse convertible notes and have to carefully select the underlying stock. We first and foremost look for high quality companies which we are willing to own in the long run. This is the reason why most of the underlying names are part of our core holdings or watch list. As the commonly used name “hybrid securities” implies, we can use them tactically from an equity or fixed income perspective. A company might offer limited upside and downside in the near term while we still believe in its long-term merits. Instead of selling and taking the risk of missing the right timing to re-enter, we can invest in a note and get paid for our patience – a yield-enhancement strategy for our equity portfolios. Another scenario could be where we buy a note instead of the underlying company due to valuation concerns. Should the stock price decline during the holding period, we have a certain amount of downside protection from the barrier, while the company’s valuation might reach a more attractive level. Thus, we collect coupons while waiting for a better entry point. From a fixed-income viewpoint we can select less volatile stocks with higher barriers for the notes, resulting in lower coupons but higher downside protection. The different motivations for buying each note will determine the appropriateness for the individual client portfolio.
We are aware that the opaqueness of structured products has the potential for high fees and we are minimizing any implicit costs by using a simple, plain-vanilla structure and not buying notes in the secondary market. We screen for potential candidates by their implied option value, price the note ourselves using third-party valuation models, and look for the best risk/reward ratio. Then we approach the main issuing banks directly for a customized note with our preferred terms. The banks bid against each other for our business, and by comparing half a dozen or more offers, we gain a good overview of the most favorable terms which usually mean the highest coupon rate for a given structure.