January 9, 2023

How structured products provide valuable diversification when interest rates rise

If one theme dominated the markets in 2022, it was inflation. Prices soared in most of the world’s major economies- hitting double digits in some cases- primarily due to Russia’s invasion of Ukraine, which drove up energy prices and disrupted supply chains.

Central banks responded by raising interest rates, the main tool they use to control inflation, from record lows. At its latest meeting in December 2022, the Federal Reserve increased the federal funds rate (which provides a benchmark for various financial products including loans and bonds) to between 4.25% and 4.5%, the highest level since the 2008 financial crisis. Other central banks have followed suit, although at a slower pace- the UK ended the year with rates at 3.5% and the EU at 2%.

The relationship between interest rates and traditional assets

Traditional asset classes tend to underperform in a rising rate environment. The stock market generally dislikes rising rates for two reasons: they increase the cost of borrowing and reduce consumer spending power, and they adversely affect company valuations (with the exception of the financial sector). To put this effect in context, the S&P 500 fell by 19.3% in 2022.

Bonds, the other cornerstone of many portfolios, are also impacted. Bond prices move inversely to rates, so when rates rise, bond prices fall as investors turn their attention to new issues paying a higher coupon. Of course, some bonds benefit from inflation, for example those with returns linked to an inflation index like the UK’s Retail Price Index (RPI).

However, alternative asset classes can outperform when interest rates rise.

How structured products benefit from rate hikes

Structured products are issued in two forms, either as a security- referred to as a note- or a deposit. When issuing a note, the provider essentially sells the client a zero coupon bond and uses the coupon to buy a derivative offering exposure to an underlying asset such as equities, currencies, commodities and even the UK’s RPI. The same concept applies to a structured deposit, where the provider uses the funding rate to purchase the derivative.

In both cases, higher interest rates allow providers to create more attractive structured products as the coupon or funding rate increases. As well as boosting exposure to the underlying asset, the client retains a bigger percentage of the upside- known as the participation rate- if it grows in value.

The price of an option- one of the most commonly used derivatives to manufacture a structured product- is quoted as a percentage of the notional value of the contract (the value of the underlying asset it provides exposure to). Let’s say that percentage is 10%. If the coupon or funding rate covers the full 10%, the client receives 100% of the participation rate. But if it only covers 5%, the product pays 50% of the participation rate.

Higher interest rates also allow clients to access structured products with greater capital protection, which is particularly valuable in volatile markets. When rates were at historic lows, some clients chose to use a small percentage of their capital to purchase the structured product because the coupon or funding rate was too low to deliver meaningful exposure to the underlying asset. However, higher rates mean clients can enjoy full capital protection. Structured deposits provide further reassurance as they’re covered by guarantee schemes which protect up to €100,000 in the EU and £85,000 in the UK.

Higher interest rates also benefit the provider’s bottom line. If the coupon or funding is 2%, the provider can widen the spread on wholesale funding rates and improve profitability.

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Even within the current environment, some markets offer more attractive structured products than others. As highlighted earlier, interest rates are higher in the US than the UK and the EU. That means dollar-denominated structured products can provide greater exposure and better participation rates. That said, central banks tend to follow the Fed’s lead, so opportunities in other markets may emerge later.

Clients can also take advantage of the impact of rising interest rates on assets such as equities. For instance, a client could ‘buy the dip’ by investing in a structured product giving exposure to the S&P 500 while benefiting from 100% capital protection. Alternatively, the client can seek exposure to an index like the FTSE 100 which typically gains from higher rates due to its weighting to the financial sector.

To learn how Futora’s end-to-end solution can help your bank streamline the process of issuing structured products, arrange a demo today.

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