There almost always comes a time when an investor becomes uneasy and wants to de-risk their portfolio. Common ways to de-risk include selling risk assets and moving to cash or other conservative investments such as fixed income.
A compelling but less well known way to de-risk while possibly generating attractive returns is by investing in Market-Linked Income Notes (MLIN). These investments have historically only been offered to institutions and wealthy investors. However, Fintech platform's emergence has made these protective strategies accessible to mainstream retail investors. Below is an example of how market-linked notes protected investors' principal during the 2022 market downturn while generating attractive returns. But first,
What is a Market-linked Income Note (MLIN).
A market-linked note is a type of structured financial product that combines elements of traditional fixed-income securities with exposure to an underlying asset, such as major stock market indices. These debt securities are issued by well capitalized banks like Morgan Stanley and JP Morgan Chase. They are designed to provide investors with the opportunity to earn returns linked to the performance of an underlying asset, index, or basket of assets, such as stocks or bonds.
Here are some key features of Market-Linked Income Notes:
One common feature of MLINs is they typically offer some level of principal protection. This means that investors may receive at least a portion of their initial investment back at maturity, regardless of the performance of the underlying assets. Most income notes offer 100% principal protection up to limited market declines.
Coupon or Interest Payments
MLINs may also provide regular coupon or interest payments to investors. These payments are predetermined, payed monthly or quarterly and are contingent on the performance of the underlying assets. The coupon payments are usually structured to be higher than what traditional fixed-income securities might offer.
Below is an example of a JP Morgan Chase, contingent income note we bought for our clients on February 11th, 2022 and matured on November 11th, 2023.
Underlying Indices: Nasdaq 100 (NDX), Russell 2000,(RTY) Russell 2000 Value ETF (IWN)
Principal Protection: 100% principal protection up to 40% index declines (worst performing index)
Coupon payments: 10.8% annual interest rate, payed monthly as long as no underlying index is down more than 30% on the monthly observation date
What happened during the 21 months that the investor held the security?
Market index returns: IWN down -16.62%, RTY down -15.99%, NDX up 8.62%, Barclays Aggregate Bond Index: -14%, cash returned low single digits.1
Meanwhile, our market-linked income note investors received 100% of their principal plus coupon payments totaling 18.9% over it's 21 month term.2 This return outperformed the referenced market indices, fixed income and cash by 10% to 34%.
What are the risks of a market-linked income note?
When the issuer of the note defaults, the entire value of the investment principal is at risk of not being repaid. This is the same risk associated with investing in any other senior corporate bond. Investing with high quality banks with strong balance sheets reduces this risk. The vast majority of notes are issued by investment grade banks.
The maximum benefit of investing in a structured note is usually realized by holding until the maturity date. There is a secondary market but it's is limited to broker dealers and their affiliates and distributors. This means that any sales made prior to maturity could be at a discount to the current market value.
Losses are only protected according to the terms of the individual note. Principal is at risk if one of the referenced stock indices is down more than the barrier level at maturity. In the example above, this level is 40%.
#4: Call Risk
Income notes usually have a call feature which means the bank can redeem the note before the maturity date. This means that investors will receive a return of their invested principal while keeping any interest payments paid to date. In the example above, the note could have been called back to the issuer after 3 months.
Why invest with a Registered Investment Advisor & Claro Advisors
As a Registered Investment Advisor, we have access to a large selection of multiple bank offerings and don't charge the fees and commissions that erode the income and protection terms of these products.
Furthermore, since structured notes are a specialty of our firm, we are proactive in leveraging our relationships to customize notes on a timely basis with superior pricing terms for our clients. In the case of the example above, this note was created during a short window of volatility to maximize benefits and minimize risk to the investor. These notes were not available to clients of the traditional banking firms.
- Source: First Trust, data from 2-11-22 through 11-11-23
- Performance figures do not reflect the deduction of investment advisory fee. Client’s return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account; Investment advisory fees are described in the Advisor’s Form ADV Disclosure Brochure.
- This content is developed from sources believed to be providing accurate information. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.