What the Zero-Rate Era Left on Your Shelf

That is when the products came into play. Here are a few that I can recall from the shelf:

• Auction rate securities
• Enhanced cash funds
• Principal protected notes
• Reverse convertibles
• Yield enhancement notes
• Range accruals
• CMS steepeners
• Market-linked CDs
• Accelerated-return notes
• Buffered notes
• Dual-directional notes
• Twin-win notes
• Snowball notes
• Phoenix autocallables with memory coupons
• Worst of Autocallables notes
• Fixed indexed annuities
• RILAs
• Defined-outcome ETFs
• Single-stock covered call ETFs
• Liquid alts
• Unconstrained bond funds
• Non-Traded BDCs
• Non-Traded REITs
• Interval funds
• Tender offer funds
• And, most recently, evergreen private credit

I laugh at several of these product names — “Twin Win,” “Snowball,” “Worst of Autocallables.” I would love to have been in the room during that last one. Some of these products were great, and some are still great today. Nearly all of these, however, earned the extra yield in the same way: The investor sold something.

What the Investor Sold

The extra yield did not come from the bond market; it came from the investor. The investor made a sacrifice. They may not have even known that they were making a sacrifice.

For the reverse convertibles products, the investor sold a put on an underlying security and, in return, received that put’s premium as the main coupon. For the autocallables products, the investor sold upside, because when the underlying rises, the note is called.

I like the memory coupons the best. If the underlying falls below the barrier, then the coupon is skipped. The note “remembers” this and pays it later if the underlying comes back above the barrier. Most retirees would prefer for the coupon just to appear.

Buffers work similarly, but in reverse. In a 10% buffer, the bank absorbs the first 10% of the loss. All subsequent losses are absorbed by the investor. The buffer gets the “headline,” and the investor gets the rest.

Cash was locked up in non-traded BDCs and interval funds, and a premium was paid for that. Which is fine, up until the point that the cash is needed back. At that point, only a small percentage of investor assets can exit the fund per quarter. This has come up with many investors this year.

For the non-traded REIT product, it appears on statements in a fairly neutral manner, since it was not priced daily. Upfront fees may be close to 10%.

The principal protected note is only as protected as the bank behind it. In 2008, for a portion of those notes, that protection was tied to Lehman Brothers, which went into bankruptcy and then winked out of existence.

I would point to the auction-rate securities as perhaps the best example. They were sold as cash. In February 2008, the auctions failed. Investors that bought these as cash found out that they were holding long-term bonds that no one would bid on.

What Were the Products Compared To?

The products did not undergo a lot of dramatic changes. What did change was what they are compared to.

In 2020, if an investor did not like a buffered product, they were given an alternative that paid almost nothing. What the buffered product needed to do was just beat zero. That was not difficult to do.

Today, the alternative pays 5.10%. If needed, that can be sold on a Tuesday morning. There is no lock-up or barrier, and there is no need to explain a memory coupon.

I give the product builders this much. They also benefit from higher rates. A principal-protected note can be thought of as a zero-coupon bond with an option attached. At 1%, a 10-year zero would cost approximately 90 cents. This leaves 10 cents for the option. At 5%, a 10-year zero would cost approximately 61 cents. This leaves 39 cents for the option. This means a product built today is better than a product built in 2015.

However, that 61-cent zero is a STRIP from the Treasury. The investor can buy this directly. There is no bank in the middle and no bank credit risk. In other words, the protection is the cheap portion of the note. The investor can buy it in most brokerage accounts without help from anyone. What is really being paid to the dealer is what can be done with the 39 cents and whether that outperforms what the investor can do with those 39 cents on their own.

Going Through the Shelf

I am not saying investors should sell all of these products. Some products do accomplish things that a bond does not. Mostly on the equity side. A buffered product can be a good fit for an investor who would otherwise just hold cash. The test for these products has changed somewhat, however. I would bet that most advisors’ shelves have not been reviewed since the rates have increased.

I would go through yours one product at a time.

First, determine what the product was purchased for. Write this in a sentence. If the honest sentence is solely, “It paid more than bonds did,” then the reason for purchasing the product is gone.

Compare the product to a Treasury or investment-grade bond with a similar duration and compare the yields. The difference between these two yields is what the investor is being paid for the added complexity.

Then determine what the investor sacrificed to receive the difference in yields. Was it a lock-up? A daily price? An option? Or the credit of a bank? Some of these sacrifices cost more today than they did when rates were at 1%. Liquidity is a big one. The ability to move money is very important, especially when a plain Treasury pays 5%.

Finally, look at the exit and what’s involved. Consider things like early repurchase fees, tender caps, notes that only one dealer will bid on, and surrender schedules. If it takes more than a page to document the exit from a product, I doubt the investor fully understood the exit at the time of purchase.

What Comes Next

People are already creating the higher-rate versions of these products on a whiteboard. These will be called innovative. They may even be good. I think the word “income” will be in their name somewhere. When these products do come out, I would ask the same questions about them that I have asked about the existing products.

For about 15 years, we created products to earn a yield that the bond market was not paying. Now, the bond market is again paying this yield, and a plain Treasury can do the job on its own.

Charles Urquhart, CFA, is the founder of Fixed Income Resources and an adjunct professor of fixed income at Loyola University Maryland’s Sellinger School of Business. He spent 30 years on institutional fixed income trading desks including Lehman Brothers, Fidelity Investments, and Tradeweb.

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