With the normalization of central bank rates, yield products should once again perform well.
With the decision of various central banks to start easing their monetary policy, the high interest rate regime that began in 2022 is expected to normalize. The Swiss National Bank was the first to cut its key rates last March, followed by the European Central Bank, the Bank of England and finally the Federal Reserve, which also recently followed suit. The latter announced on September 18 a “jumbo” rate cut of 50 basis points, thus placing the American economy on the path to a soft landing.
Currently, the market expects the majority of central banks to ease rates by between 150 and 200 basis points by the end of 2026. In 2025, the pace of easing is expected to be more sustained, particularly for the Fed. The end of the easing cycle is expected in the second half of 2025 for most central banks in developed countries.
In this market context, what is the impact of a drop in rates on structured products?
The vast majority of structured products consist of an “option” part and a “financing” part. The latter is impacted by the level of interest rates as well as the cash flow needs of investment banks. When interest rates fall, all things being equal, the financing portion of the note will offer a lower yield and, therefore, the terms offered to investors will be less favorable.
Certain categories of structured products, by their nature, are more sensitive to movements in interest rates. This is particularly the case for guaranteed capital. It had disappeared from banks’ offerings since the 2008 financial crisis and made its return to investors’ portfolios in 2022 with the rise in interest rates. The guaranteed capital is constructed with a zero-coupon bond and an option that offers participation in an underlying or a coupon. The zero-coupon bond ensures the repayment of the note at maturity and the financing of the purchase of the option. The combination of low volatility and high rates provide optimal conditions for its design. Therefore, a decline in interest rates is not conducive to notes with capital protection and investors’ interest may suffer. However, it still remained possible to use these instruments by considering longer maturities or even to put a small part of the capital at risk.
The Credit Linked Note, also known as a synthetic corporate bond, is another type of structured product whose terms will deteriorate significantly as the interest rate environment changes. This financial instrument is considered an alternative to investing in a traditional bond. It also consists of a zero-coupon bond issued by the issuer and a Credit Default Swap of the reference entity.
Yield products, such as Barrier Reverse Convertibles or Reverse Convertibles, are the most popular instruments with structured product investors. They offer regular, guaranteed or conditional income based on the performance of an underlying with conditional capital protection. Over the past two years, they have faced competition from bonds, after years of benefiting from low or even negative yields. Indeed, before the rise in rates which began in 2022, investors looking for yield had naturally turned to yield optimization products to compensate for the low profitability of a bond investment. With the normalization of rates, yield products should once again perform well. In addition, they offer better conditions when volatility is high. In a context of falling interest rates, financial markets are likely to be more volatile, which will allow yield products to become more attractive to investors looking for regular income.
Finally, what are the consequences of a normalization of monetary policies on existing structured products? The price of structured products on the secondary market should react positively to the drop in rates because the “financing” part of the note will increase in value. Of course, the impact will depend on the type of product and its rate sensitivity.
The financial landscape will be reshaped by the normalization of interest rates, and structured products will not be spared. Indeed, the performance profiles of different types of instruments will be redefined. This new market context will therefore create new opportunities for investors, while redistributing the cards within the world of structured products.
Source : Mirabaud & JP Morgan – Global Fixed Income Markets – 21.09.2024
