Rate-Linked Notes are medium-term notes, typically structured as callables, that offer the potential for an above-market rate of interest. This variable interest rate is based upon a formula that is tied to the performance of one or more interest rate components. The most common interest rate structures are LIBOR Range Accruals, CMS Steepeners, Non-Inversion Notes, and Inflation-Linked Notes.
Rate-Linked Notes and CDs offer 100% principal protection, if held to maturity and the issuer is able to fulfill its obligation. Rate-Linked CDs also carry the added benefit of FDIC insurance up to applicable limits (visit FDIC.gov for complete details on deposit insurance).
Types of Offerings
Libor Range Notes
Medium term notes or CDs offering an above market coupon as long as the London Interbank Offered Rate (LIBOR) trades within a certain range (ex. 7% coupon as long as 6mo LIBOR is between 0-6.50%). The interest accrues at the stated interest rate for every day that LIBOR satisfies the range. For each day that LIBOR trades outside the range, interest will accrue at 0%.
Medium-term notes or CDs offering an above market coupon as long as the spread between two stated maturities on the Constant Maturity Swap (“CMS”) curve do not invert. The interest accrues at the stated interest rate for every day that the curve is not inverted (ex. 10% as long as 30yrCMS – 10yrCMS is greater than 0%). For each day the curve is inverted interest will accrue at 0%.
Medium-term notes or CDs offering an above market coupon for one to two years, followed by a leveraged variable interest rate thereafter based on the difference between two Constant Maturity Swap rates (“CMS”) (ex. 10% for 1 year, thereafter coupon equals 4 x (30yrCMS – 2yrCMS) ). The variable rate coupon pays a higher rate of interest when the treasury yield curve is “steep” (when long treasury yields are higher than short treasury yields). The leveraged coupon is typically subject to a cap (maximum interest rate).
Medium-term notes or CDs offering a variable rate of interest indexed to inflation. While there are many different types of structures, CPI-linked floating rate notes commonly pay interest determined by the annual percentage difference of the Consumer Price Index (“CPI”) as measured by the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (“CPURNSA”) published on a monthly basis by the Bureau of Labor Statistics of the U.S. Department of Labor. CPI-linked notes and CDs are tools investors can use in an effort to keep in step with inflation.
While Rate-Linked Notes and CDs can use a wide array of underlying interest rate indexes, here is a list of the most commonly used:
London Interbank Offered Rate (LIBOR)
The rate of interest at which banks borrow funds, in marketable size, from other banks in the London interbank market. LIBOR, the most widely used benchmark or reference rate for short term interest rates, is an international rate. The London Interbank Offered Rate is fixed each morning at 11 a.m. London time, by the British Bankers’ Association (BBA). The rate is an average derived from 16 quotations provided by banks determined by the British Bankers’ Association, the four highest and lowest are then eliminated and an average of the remaining eight is calculated to arrive at the fix. Eurodollar Libor is calculated on an ACT/360 day count basis and settlement is for 2 days hence. (Source: Bloomberg)
Consumer Price Index (CPI)
Established by the U.S. Bureau of Labor Statistics, the CPI is one of the most significant gauges of inflation in the United States. The CPI is calculated by establishing the price of a fixed basket of goods and services, which are selected because of their direct impact on average citizens. Included in the basket are such things as food, gasoline, housing, and medical care. Increases in the costs of such items indicate a rise in the inflation rate. Also known as the Cost-of-Living Index. (Source: Bloomberg)
Constant Maturity Swap Rates (“CMS”)
A variation of the fixed rate-for-floating rate interest rate swap. The rate on one side of the constant maturity swap is either fixed or reset periodically at or relative to LIBOR (or another floating reference index rate). The constant maturity side, which gives the swap its name, is reset each period relative to a regularly available fixed maturity market rate. This constant maturity rate is the yield on an instrument with a longer life than the length of the reset period, so the parties to a constant maturity swap have exposure to changes in a longer-term market rate. (Source: Risk Institute)
May Be Suitable for Investors Who Are:
- Seeking market exposure but not willing to risk their principal to get it
- Looking for enhanced yield opportunities versus traditional fixed income
- Trying to hedge against rising rates and/or inflation
- Seeking to manage overall portfolio risk
- Variable coupon based on performance of the underlying asset (may be subject to cap)
- Low minimum investment. $1000 minimum initial purchase; $1000 increments thereafter.
- High potential coupon, versus comparable fixed income products of the same credit rating and maturity
- High credit quality. Typical issues are from banks with a credit rating that is investment grade or better, although credit quality should not be the sole basis for an investor’s decision.
Considerations & Risks
- Principal Risk: These notes offer 100% principal protection, if held to maturity and the issuer is able to fulfill its obligation. If sold prior to maturity, the investor may receive less than their initial investment.
- Variable Return: Rate-Linked Notes could pay 0% interest; the variable interest rate the investor receives may be lower than the yield on other debt securities.
- Liquidity: While there may be a secondary market, issuers are under no obligation to maintain one. Selling prior to maturity carries with it the inherent risk factors that can affect marketability, such as volatility of the underlying assets, interest rate swings, and developments affecting the underlying issuer.
- Reinvestment Risk: An early call prior to maturity may put the investor at risk of reinvesting in a lower interest rate environment.
- Creditworthiness of the Issuer: The extent to which any principal is protected is subject to the quality of the issuer’s credit. Structured Notes are subject to the risk that the issuer might not be able to meet scheduled interest or principal payments. The investor should investigate the creditworthiness of the issuer to evaluate its ability to meet the terms of interest and principal payment.
- Taxes: For full information regarding the tax consequences of Rate-Linked Notes, investors should consult their tax advisor.