The use of structured hybrid products has picked up tremendous momentum recently as financial institutions seek opportunities for increased investment portfolio yields.
Structured hybrid products combine two assets to form one security. Generally issued by large financial institutions, these synthetic investment instruments combine a fixed-income security's principal safety with the return potential of equities, commodities, credit spreads, or key interest rate indicators.
The more prominent structures in the marketplace include:
Principal protected notes. These notes provide a return of principal at maturity, plus a small annual coupon and a percentage participation in the return of equity index, hedge fund, commodity, currency, etc.
Range accrual or accrual notes. These notes are designed to pay above traditional fixed-income market coupons as long as an underlying key interest rate or credit indicator stays within a certain preset range.
Synthetic collateralized debt obligations. These types of investments have grown with the booming credit default swap market. They are collateralized by highly rated bonds and credit derivatives and rated based on tranche seniority.
These CDOs have gained popularity due to their ability to offer floating or fixed rates, spreads generally above those of other types of fixed-income securities of similar credit quality, and overall collateral flexibility and diversification
There are six primary drivers that make SHPs attractive investment assets for some bank investors:
1. Market conditions are tight, and traditional credit and yield curve plays are not readily available.
2. While regulatory restrictions prevent banks from investing in specific asset classes (such as equities), certain SHPs provide safe and sound access to these asset-class return profiles.
3. Investment diversification can be achieved either through coupons, which are uncorrelated to other bank assets, or through credit diversification.
4. Accounting benefits are enjoyed by some SHPs. For example, synthetic CDOs don't require the credit default swaps portion to be marked to market.
5. Risk-based capital benefits allow some structures to have underlying collateral with lower-credit-quality assets, while the notes themselves are highly rated securities based on seniority.
6. Placing certain SHPs in bank-owned life insurance products may achieve tax-advantaged returns.
Recent turbulence in the financial markets resulting from the credit crisis has increased the need for investors to consider the risks inherent in some of the above assets.
Because the markets are constantly evolving in the SHPs arena, banks entering into this sector of the fixed-income universe should have an investment strategy and specific goals in mind. Banks should look for investment grade issuers that offer customization in terms of issue maturity, coupon link, call features, etc., as well as expertise in secondary market trading and an ability to provide liquidity.
At the same time, banks should be cautious when considering SHPs in general — proper due diligence is critical.
Event risk — the potential for positive or negative changes in the note's return profile based on the occurrence of certain events — will also need to be addressed. For those banks that wish to proceed, SHPs must first undergo a detailed feasibility analysis to determine if SHPs make sense for their organization.
This analysis should include conceptual usage strategization, research and data gathering, scenario analysis, event modeling, and ongoing strategy solidification. After the feasibility analysis, a bank can obtain internal approvals to move forward with structure design, issuer selection, and strategy execution.
SHPs can offer unique risk/return opportunities to bank buyers, and the use of these securities will likely continue to grow.
