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Rate-linked products

Rate-linked structured products help combat capital erosion, especially during periods of inflation.

When interest rates tend to rise and financial markets are volatile, the appeal for interest rate-linked structured products increases. These products help combat capital erosion, especially during periods of inflation. Even though inflation may sometimes exceed the returns offered by these products, they remain a real alternative to so-called 'risk-free' investments (deposits and term accounts, euro funds, highly rated government bonds, etc.).

They offer both daily liquidity and capital guaranteed at maturity. An environment of positive and relatively high rates is necessary for these products to be created. As these products almost entirely offer total capital guarantee at maturity, their bond base must provide sufficient yield to purchase the option necessary for the creation of a structured product and to guarantee the capital at maturity.

For some investors - particularly corporate treasurers, foundations, associations, pension funds, mutuals, or institutions, they represent a significant portion of their allocations. They are often subscribed to through securities accounts and Luxembourg life insurance, but also for individuals through French life insurance.

💸 How does the rise in rates influence returns?

A structured product consists of an option and a bond base. A bond is a piece of debt issued by an entity seeking to raise funds, which pays interest to the holder. In the case of structured products, these interests are not directly paid out but are used to finance the optional part of the product.

When rates increase, the interests from this bond base also increase, which mechanically improves the return. In other words, the present value of the bond base is lower, and with these interests, a larger quantity of options can be purchased.

🏦 Different underlyings

The underlyings used for interest rate structured products vary, but often include:

  • Constant Maturity Swaps (CMS): these are swap contracts - bilateral exchange contracts - based on a variable forward interest rate with a constant maturity. The variable interest rate is generally linked to a reference rate, such as Euribor or Libor, and the maturity ranges from 1 to 30 years;
  • Euro Interbank Offered Rate (Euribor) or London Interbank Offered Rate (Libor): both are benchmark interest rates used for financial products. Euribor is the interest rate at which banks lend to each other for Euro-denominated contracts, while Libor is the interest rate for Dollar-denominated contracts.

❓Some examples

Fixed Rate: this is a product with a guaranteed fixed interest rate. It is the simplest and least risky type of product. It is often used as a direct alternative to deposits and term accounts, euro funds, and highly rated government bonds.

Fixed Rate Callable: similar to Fixed Rate, but it gives the issuer the option to call the product at their discretion. Theoretically, if rates have fallen at an observation date, the issuer will call the product because it costs them more to pay a higher rate than the current rates. Conversely, they will not call the product if the current rates are higher than the product rate. This feature allows the issuer to reduce their borrowing costs if interest rates continue to fall, and thus offers a better return than a classic Fixed Rate.

Floored Floater: this product guarantees a minimum coupon - floor - while benefiting from the rise in the underlying rate (e.g., Euribor) in exchange for a capped yield - cap. It can also be callable by the issuer.

Steepner: offers a yield dependent on the slope of the yield curve. This slope is calculated as the difference between two swap rates, the Constant Maturity Swaps (CMS), sometimes with leverage. For example, the coupon can be equal to 2 times the difference between the 5-year CMS rate and the 3-year CMS rate. The yield will be high when the yield curve is steep, and low when it is flat. Such formulas are sometimes supplemented by a minimum coupon - floor - that prevents the rate from becoming negative when the yield curve is inverted, and a maximum coupon - cap - that limits potential gains in case of a steep slope.

Tarn (Target Accrual Redemption Note): a rate structured product similar to the Steepner but with an automatic early redemption mechanism. It offers a yield dependent on the slope of the yield curve, defined as the difference between two swap rates - CMS - sometimes with leverage. It can be redeemed early when, at an observation date, the sum of the received coupons (accrual) reaches a predefined level set at the product launch - the target.

🤓 To summarize

Interest rate products offer both daily liquidity and capital guaranteed at maturity. An environment of positive and relatively high rates is necessary for these products to be created. For some investors - particularly corporate treasurers, foundations, associations, pension funds, mutuals, or institutions, they represent a significant portion of their allocations.

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