10% Fixed Rate CDs.....
I am more than confident most if not all of you have heard the term Structured Products and even Steepener Notes. I was wondering if some of our friends can give us a little more info on how these products are actually structured and more importantly how they are able to produce the fixed returns they claim. For clarification I am referring in particular to Steepener Notes with FDIC protection and qualify as CDs. For example, this month JPM is offering a new issue for a CD with a duration of 30 years (they don't need to be held to maturity and can be sold early similar to a bond and some even offer a death put) with a fixed rate for the first year of 10% and variable from years 2 to maturity based on the spread of the 30 and 2 year CMS rates (Constant Maturity Swap) minus a "fee" of 87.5 bps multiplied by 5 (Leverage factor usually ranges from 4-5 on the CDs but the rest of the formula is pretty consistent from bank to bank). My question is first how and why they offer such high rates with what seems to be little to no risk. I understand through leverage via swaps and leverage they can obtain these returns but why pay this out when a investment with similar risk pays no where near the this rate. Any information regarding the structure of these products and how these returns are created would be greatly appreciated. If you guys need any more information on the products to explain leave a comment or PM me. Seems like a great investment for your average investor or someone that has to deal with a lot of red tape in there investments like bankers or consultants; I'm sure the brofessor may be able to shed some light on these products as I am sure they are popular in the PWM space.
long time reader first time poster,
The BroHon
If it sounds to good to be true....
I would like to know more though.
@"thebrofessor"
edit: just read this again, not familiar with steepener notes, the main structured products that are used around the office are autocallables, which basically pays high income if a stock is not volatile, has limited liquidity, and usually matures in 1 year. What you're talking about sounds like a type of brokered CD, and I'm shocked that it's FDIC insured if it pays 10% then a variable rate. the variable rate makes sense, as with most things, that's the bank limiting its interest rate risk (one of the beauties of floating rate if you're the bank), but I'm sure that JPM's mathematicians determined this was a beneficial product for both them and for the client.
without doing some more due dili on this, I can't give you detailed answers, but I'll tell you some of the tenets of our practice and you might get the gist of why we don't own stuff like this:
chasing yield never ends well
if you can't understand how it works after 2 or 3 passes, you should pass as well
if it sounds too good to be true, it is. not probably, it is too good to be true
part of the yield pickup here is liquidity premium (most structured products are illiquid except on certain dates
derivatives are weapons of mass destruction for the individual investor (stolen from Buffett but edited).
futhermore, structured products are like insurance policies, you can't buy them en masse and then distribute amongst clients like you can blocks of stock. so we can't put these things in our models and instantly have all clients in that model own it, we'd have to call hundreds of people to get permission to do it. that's not an efficient way of doing business, and I've yet to see a case where it's better for the client than what we're already doing.
also, structured products are very available, but my casual observation is that they're not used very much for teams like ours, rather, the shift is toward the AM model (% fee based on AUM).
/rant
If you do the formula it comes out to roughly 10.5% if it were to be paying the variable rate today (Although the majority of these products are capped at the first year rate; in this instance 10%) basically my understanding is it is a highly leveraged hedged CDS (credit default swap) strategy designed to provide constant income by basically creating credit spreads. The FDIC insurance I believe is allowed because they will take a portion of the initial capital and put it into treasuries that will equal the total initial capital raised by maturity. For example for every 100 dollars received by JPM 80-90 will go to treasuries and the interest paid will equate to the full 100$ at maturity (for this product example 30yrs) then the 10-20 dollars that was left over will be leveraged (typically 50x, hence the 5x multiplier in formula from op) and deployed into the credit spread. Now if the curve flattens or becomes inverted the credit spread will not pay but neither will the "CD" based on the formula. I have seen this strategy used in many market linked CDs also and the products prove to be extremely profitable for the banks. I have seen some endowments and family offices employ this strategy but initial capital has to be 50-60mm at a minimum for it to be cost effective. You can usually pick them up in the secondary 5-10 points cheaper after issuance and liquidity is tough but can be done with the right relationships. Definitely not a product for an average AM type team for the reason brofessor explained but they seem to be gaining popularity lately with people looking for a yield and want to take advantage of the yield curve "steepening". Although I am not 100% on everything I just said as I did most of my research this morning I think that may help a little. Sorry about the terrible writing; I am all over the place right now trying to finish a few thing before the end of the day.
Sb for both of you. What kind of liquidity do these things offer? I would assume not much but thats not a bad return right?
liquidity can be tough but you can find buyers. alot of the wholesalers will buy them back but theyll offer 4-5 points below market. im more familiar with market linked. For example theres one from MS offering 175% participation in the S&P and you dont start losing money until the index falls below 50% of initial value when you bought it. Those tend to be a bit more liquid mostly due to shorter duration and more transparency.
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