As equity markets get volatile amid global growth worries and trade tensions, structure notes can be an interesting component of investors’ overall equity portfolios.
Global investors are starving for yield
The combination of lower central bank policy rates, low growth and inflation expectations, and scarcity of bond supply are all pressuring yields lower. For many investors, generating a high, sustainable income is becoming more challenging. Traditional sources of income, such as bank deposits and bonds, may no longer be sufficient to meet their real spending needs. Equity dividend can be another source of yield. However, global dividend yields are hovering at multi-year lows, and vary among sectors and countries. If investors focus singularly on the highest yielding securities, they may find their portfolio not well-diversified and may become vulnerable to downside risks.
As we have entered into a late cycle environment for investing, we view the upside potential of global equity markets to be in single digits, given that multiples are near fair values and earnings revisions are likely to be skewed to the downside. Also, ongoing trade uncertainty may continue to weigh on corporate confidence and growth. As such, investors may also want to focus more on generating returns from yield rather than capital appreciation.
Structure notes* to enhance risk-reward profile
Volatility tends to increase in an uncertain environment, and structured notes can be an interesting component of investors’ overall equity portfolios. When an investor buys a stock, he/she buys the potential for unlimited upside capture, as well as the downside risk of a full capital loss. Through structured notes, investors can opt to give up some (or all) of the potential upside in exchange for some downside protection (and also a fixed coupon in the case some particular types of structures). In this way, the investor effectively changes the risk-reward profile of the stock investment, providing an upside capture which he/she is comfortable with, and the added benefit of certain downside protection.
Increase in volatility entails better economic terms for these types of structured notes, meaning that investors can expect more attractive downside protection levels and/or coupon rates. While volatility may not be welcomed by most investors, in some circumstances they can use it to their advantage and create an investment vehicle to weather adverse market conditions, and to stay invested through a volatile market.
Harvest yield by investing in Fixed Coupon Notes
A Fixed Coupon Note (“FCN”) is an equity-linked structured note which pays a fixed coupon on a periodic basis, regardless of performance of the underlying asset (the “Underlying”) which can be stocks, exchange traded funds (ETFs) or market indices.
The FCN will be early redeemed at 100% of notional when auto-call is triggered (when the Underlying closes at or above the Auto-call Barrier) on any periodic observation date. Investors will receive the fixed coupon up to the period of the occurrence of auto-call. If early redemption has never been triggered, the FCN will be redeemed at 100% of notional at maturity if the Underlying closes at or above the Strike on the final valuation date. Otherwise, the FCN will be redeemed in the form of physical delivery of the Underlying shares (Number of shares = Notional of the FCN divided by the Strike).
An example of how an FCN works is shown as below.
An FCN helps investors to enhance their portfolio yields with periodic coupon payments, and provides a buffer to price downside of the underlying (investors only exposed to downside if the final price of the underlying is lower than the Strike). It allows investors to tailor the risk-reward profile according to their specific investment outlook, and could potentially generate better returns in a range-bound market.
Systematic investing in a portfolio of Fixed Coupon Notes
To unlock yield in equities with diversified risk exposures, investors can consider systematically investing in a portfolio of FCNs. This does not only help mitigate the risks of market timing, diversify risk exposures across different sectors and regions, but may also allow investors to benefit from short-term volatility changes (increase in volatility entails better economic terms).
To construct a diversified portfolio of FCNs, an investor determines the target portfolio size, target notional per FCN and invests a portion of the target portfolio funds into a selection of FCNs at inception. The investor will then gradually allocate the remaining portion of the portfolio funds into FCNs at regular time intervals, and reinvests redemption proceeds to new FCNs when the existing ones matures or early redeemed.
An illustration of how an FCN portfolio is constructed and maintained is shown as below.
Periodic portfolio review and dynamic rebalancing of risk exposures will be crucial, to ensure diversified risk exposure across different sectors and regions, and to enhance performance of the overall FCN portfolio in accordance with investors’ yield expectation and targeted risk-reward profile.
* Structured product involves derivatives. Do not invest in it unless you fully understand and are willing to assume the risks associated with it. The most common risks include, but are not limited to, risk of adverse or unanticipated market developments, issuer credit quality risk, risk of lack of uniform standard pricing, risk of adverse events involving any underlying reference obligations, risk of high volatility, risk of illiquidity/little to no secondary market, and conflicts of interest. Before investing in a structured product, investors should review the accompanying offering document, prospectus or prospectus supplement to understand the actual terms and key risks associated with the each individual structured product. Any payments on a structured product are subject to the credit risk of the issuer and/or guarantor. Investors may lose their entire investment, i.e., incur an unlimited loss. The risks listed above are not complete. For a more comprehensive list of the risks involved with this particular product, please speak to your J.P. Morgan representative. If you are in any doubt about the risks involved in the product, you may clarify with the intermediary or seek independent professional advice. In discussion of options and other strategies, results and risks are based solely on hypothetical examples cited; actual results and risks will vary depending on specific circumstances. Investors are urged to consider carefully whether option or option-related products in general, as well as the products or strategies discussed herein are suitable to their needs. In actual transactions, the client’s counterparty for OTC derivatives applications is JPMorgan Chase Bank, N.A. and its affiliates. For a copy of the “Characteristics and Risks of Standardized Options” booklet, please contact your J.P. Morgan Advisor.
Key Risk Disclosures
The product description is intended to be indicative, preliminary and for illustrative purposes only. This document should not be relied upon in isolation for the purpose of making an investment decision. The final terms and conditions may vary. Please read the termsheet and any other relevant transaction documentation, which will include a fuller disclosure of the relevant features and risks of the product, for details. Charts and scenarios are for illustrative purposes only. Historical performance is no guarantee of future performance. Please see important disclaimer at the end of this document. For more information on product profiles and trade ideas, which discusses risks, benefits, liquidity and other matters of interest, please contact your J.P. Morgan representative.
Some of the products and/or services mentioned may not be available in all jurisdictions.
This document is confidential and intended for your personal use only. It should not be circulated to any other person without permission and any distribution, or duplication by anyone is prohibited. WARNING: The contents of this document have not been reviewed by any regulatory authority in Hong Kong, Singapore or any other jurisdictions. You are advised to exercise caution in relation to the document. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice.