Uncertainty about the stock market has helped revive interest in complex derivatives known as structured notes.
Investors experienced big losses on structured notes three years ago when interest rates rose. But traders said recent volatility in the stock market has prompted investors to add to their bond portfolios.
Traders at Merrill Lynch & Co., J.P. Morgan & Co., and other big trading banks are finding investors-most often European banks and insurance companies-willing to make leveraged bets on bonds with exotic features added to boost their yields.
Spreads on most "plain vanilla" fixed-income products, such as municipal bonds and government notes, have shrunk greatly as European and Japanese investors have flooded the market, attracted to the bonds' high yields compared with similar securities abroad.
At their most baroque, structured notes can be ordinary government bonds with a complex yield enhancer, such as the American rate for federal funds minus the London interbank offered rate plus the difference in values of the Finnish mark and the Swiss franc.
Such instruments wound up in the hands of unsophisticated investors, who three years ago experienced heavy and unexpected losses when interest rates rose quickly in early 1994.
But what really hurt investors, traders say, was not the complexity of the structured notes, but the degree of leverage involved.
Investors were seeking much more aggressive returns from structured notes in 1994 than they are nowadays. Traders say investors typically seek an extra 50 basis points of yield from structured notes, where as 250 points was the goal three years ago.
In addition to leveraging less, investors are also demanding protections against losses in case their bets turn against them.
Structured notes often protect the principal against loss nowadays, said Frederick J. Chapey Jr., global derivatives executive at Chase Manhattan Corp.'s securities unit. This protection enables investors to speculate on the market without losing their shirts.
"If they're right on something, they get a higher yield. If they're wrong, they get a lesser one," Mr. Chapey said.