I’m just doing research on this because my father had invested in these a couple years ago.
I am confused as to what a coupon rate is and what this is related to?
Is “structured notes” another way of calling this type of investment?
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Thanks
In: 1
Okay, these are a pretty complicated financial instrument so you’re going to have to kind of bear with me here. Also, without knowing too much about your father’s financial situation, if you’re having to figure this out yourself and you don’t have a financial advisor explaining to you exactly what this instrument is, it’s a terrible idea to invest in it.
The bottom line is that these notes are an investment that pays returns to the investor, but only if the value of whatever the note is supposed to track falls within a particular range. The reason I’m being so vague about what they track is that these notes can be defined as tracking a stock market index or an interest rate or really anything that’s observable.
Let’s look at a specific example. This is the investment prospectus (which, in case you don’t know, is just a document explaining exactly what you’re buying and usually required to tell you about some risks and advantages, regulations vary between countries) for “autocallable contingent coupon (with memory) barrier notes linked to the S&P500 index” sold by the National Bank of Canada.
https://investor.bankofamerica.com/regulatory-and-other-filings/current-reports/content/0000891092-20-007442/0000891092-20-007442.pdf
This is an even more complicated instrument than what you specified in your title, but it covers everything you’re asking about.
First I’ll explain what the heck this thing is. This instrument is fundamentally an investment in the entity that is selling it to you. That might sound confusing because it notionally tracks something that’s probably unrelated, like the S&P 500, but your actual agreement is with, in this case, the National Bank of Canada. The National Bank of Canada is promising to pay you money in the future under some specific conditions. If those conditions aren’t met, or if the National Bank of Canada goes bankrupt, you might not get any returns at all. In fact, you might lose all of your investment. In this way, they’re the same as buying any generic corporate bond.
The way the transaction works is that you pay the bank $10 up front.
Under certain conditions, they will pay you the “coupon” amount of at least 22.5 cents, but no more than 25 cents, once every 3 months for 24 months. (The reason this kind of thing is called a coupon payment is that when bonds were sold as pieces of paper, they came with detachable portions called coupons, and you would present those coupons to the issuing bank in return for your money. You would literally tear pieces off of the bond and give them to a clerk and in return they would give you money.) Under certain conditions, at the end of those 24 months, the bank will return your $10. So, if those conditions are met, you stand to make at most $12 from your initial $10 investment (which is a pretty good return for 2 years), but as I will explain, you could also lose most or even all of the money.
In a “normal” bond, you just loan the bank some amount of money and they promise to repay you some other amount of money over a period of time. Assuming it’s a fixed interest rate, you know exactly how much money you’ll get from every coupon payment and therefore how much money you’ll earn over the life of the bond.
The reason these things are “contingent” is that the bank only pays you under certain conditions. For the instrument I linked, the bank tracks the value of the S&P 500 Index. Every 3 months, it checks whether the value of the index is higher than the starting value (so, if we just say the starting value was 100, it checks whether the current value is higher than 100). If, on any of those checks, the index is higher than the starting value, the bank buys your bond back and pays you $10, plus any coupon payments you would be entitled to. This is the auto callable part. The bank can call back its money, so to speak, if the index goes up. So this is not something you would buy if you think the S&P 500 is going to go way up. You really wouldn’t make any money.
The thing is, in addition to limiting your upside, the bank also doesn’t pay you your coupon payment if the value of the index is less than 80. Let’s say the S&P 500 goes from 100 to 75 in the first three months you own the bond. At the 3 month evaluation point, the bank sees that 75 is smaller than 80, and you get nothing. But if the value were 81, you would get your coupon payment. This is the “coupon barrier”.
The memory part is irrelevant to your specific example, but what it means is that if at any time you are entitled to a coupon payment, you get all of the coupon payments from the past that you otherwise would not have gotten. So if the index goes from 100 when you buy it to 75 at 3 months and then back up to 85 at 6 months, on that 6-month coupon date you get paid for both coupon periods even though the index was lower than the barrier for the first one.
Finally, and this part really kind of sucks, at least for the specific notes I linked, there is a “threshold value” specified. What this means is, as long as the index doesn’t go down too much, you won’t lose money, but if it goes down a lot, you do. In this case, the threshold value is 80. Let’s say that at the end of the 24 months, the S&P 500 has gone down a bunch and is now at 60 compared to the value of 100 when you bought this bond. In this case, the bank doesn’t even give you $10 back. It only gives you $6 back. But the threshold value is 80, and if the index ends above 80, then you get the full $10 back.
What all of this means is, these are very specific financial instruments that should only be used by people who need them for a very specific reason. The example I gave is only useful to people who think that the S&P 500 will go down, but not by more than 20% at the end of the two-year period. In that case, they get up to a 20% yield on the bond (minus fees). But if the S&P 500 goes down more than that, they might get much less than their initial investment back, despite the fact that they didn’t actually invest in the S&P 500. And if the S&P 500 goes up, then the bank calls in their note and they get potentially nothing in terms of gain depending on when that happens.
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I hope that was clear enough to be helpful. These things are pretty complicated, and one of the reasons why is that, as I said, only very specific investors would really be attracted by them, investors who have specific ideas of where the market will go within a certain narrow range, or investors who want to buy this kind of thing to hedge their bets, or both.
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