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Structured Notes and Imperiales

Updated: Jul 20, 2023

I lived in in Guanacaste, Costa Rica in 1988. I was an exchange student, and I (infrequently) attended the Liceo Laboratorio de Liberia.


My Costa Rican family is special. I have six “Tico” brothers and sisters. My mamá, Mireya Hernandez Faerron, was the country’s Vice Minister of Education, and my papá, Julio Jaén Contreras, was a lawyer and judge who was aptly declared as a Distinguished Costa Rican by the Institute of Hispanic Culture for his work in defense of the rights and values ​​of our province of Guanacaste.


Guanacaste is a lot different now. For one, Don Julio is no longer with us; I miss him terribly. But I just got back from a week there, and make no mistake about it, our family reunion was one big party.


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When I lived there in 1988, I surfed everywhere, up and down the entire west coast and even some of the east coast. My family had a large farm, and riding horses was a big part of life. I was young enough that drinking beer was an activity unto itself, so we did quite a bit of that, too. Here, we see just how much beer is a part of Tico culture as a young man-- clearly a staunch patriot-- brought a banner with Costa Rica’s national bird all the way to their soccer match in Qatar back in 2020:




When they expanded the Liberia airport several years after I graduated, the tourism industry began to really take off in Guanacaste. There are now guided river rafting adventures, ziplines, mountain bike tours, and even an Arnold Palmer signature golf course at the Four Seasons.


So, my activities for this trip were a little different than they were in 1988-- although we still surfed our brains out. Just different accommodations-- a 44’ air conditioned boat instead of a pup tent in the jungle.


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Since last year, we have invested in quite a few structured notes for clients, but in much the same way that Guanacaste has changed since 1988, the kind of notes we’re buying now are vastly different than what we were doing a year ago. I think structured notes sometimes get a bad rap because they’re sooooo frequently misused, but they’re highly customizable, and that has been useful for addressing market turbulence while maintaining fidelity to one’s asset allocation and overarching financial plan.


Volatility and interest rates are the two factors that most influence the pricing of derivatives.


  • Increases in volatility make investors want to hedge more, so that effect on pricing is essentially a result of increased demand.


  • Interest rates affect options pricing because investors want to know how the riskless rate of return compares to the cost of insuring a risk over the same period.


So, last summer, we were buying “growth notes.” Most of what we were buying were notes that mature in five years. Upon maturity, the investor will receive a return queued off of an underlying index, say the S&P 500.

There’s a multiplier on the upside; 1.25X – 1.4X is relatively common. For example, with a 1.25X multiplier, if the S&P 500 is up 10% at maturity, the investor makes 12.5%. There’s also a downside barrier; 75% - 70% is common. At maturity, with a 70% barrier, if the S&P 500 is worth at least 70% of its original value, the note will mature at par, meaning the investor suffers no loss even though the underlying index is down.


The vast majority of our clients have comprehensive financial plans that prescribe a certain asset allocation. We subscribe to the value of investing for the long term and not attempting to time the market, but last Summer was clearly a time when we felt risks in the stock market were heightened. Using the structured growth notes was a way to maintain our asset allocations while providing a healthy dose of downside protection.

Another rationale for those kinds of notes had to do with the pricing of options. We saw some solid surges of volatility in March and May of last year, but interest rates were at all-time lows. For that reason, buying the growth component of the note was getting done relatively cheaply.


Fast forward a year. Rates on five year bonds went from 0.5% to well over 3% (and are currently higher than yields for ten year bonds—as are two year Treasuries), the VIX-- often referred to as the stock market’s “fear index”-- just spent the end of Q2 up around the spike highs of March and May 2021, as did the put:call ratio, which spiked from from .44 to .78 and spent last week around .75. …Let’s face it, options were bound to get a lot pricier.


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In order to take advantage of these market phenomena, we turned to “income notes” in 2022. We do most of these the same way; they all mature in one year and pay what we feel are considerable annual yields. They have an underlier just like the growth notes, so let’s use the S&P 500 index again as an example.


With an income note of this kind, it will mature in one year and pay, say, a 9% coupon. It will also have a downside barrier; again, around 70% is very common. So, at maturity in a year, if the S&P 500 is worth more than 70% of its original value, the note matures at par and the investor has pocketed 9% over the course of the year.


These notes are typically callable after three months, meaning that if the underlying index is worth more than its original value after three months, the investor gets called away at par having collected an annualized return of 9% up to that point.


The reason for structuring income notes these days is because the income is generated by selling options, and as we discussed, they’re expensive right now. In 2022, we’re getting both volatility and increased interest rates, so we’re using the high cost of options to our advantage.


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This is not a recommendation for everybody to run out and buy structured notes. Far from it. Rather, I write this in order to explain some of the thinking behind our portfolio management practice here at RG. Interest rates and volatility are high-- how do we take advantage of that? We utilize a structure that sells options instead of buying them, and we wrap it up in a beautiful package with a bow on it and an investment-grade credit rating.


Plus, I like the timeline for these income notes based on our market outlook. We foresee the market continuing to struggle this summer (although we appreciate that there will be more bear market trading rallies like that of this week), so collecting a large annualized coupon over that period is appealing. On the other hand, I’d love to see them get called-- I think that would happen right about the time legitimate opportunities to use a return of principle to buy stocks will arise.


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When it comes to structured products of all shapes and sizes, we strongly recommend that you speak with us before investing. Otherwise, you might just think you won the lottery.




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