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Fixed income: Capital at risk? - 17/05/2023

Reverse Convertible Notes/ Fixed Income plans are a specific type of structured investment that generate unconditional income over a fixed term. Capital is still placed at risk, albeit with a degree of downside protection through the incorporation of a capital protection barrier. To compensate for the risk of loss, fixed income plans pay interest that is greater than conventional debt from the same issuer, maturity and seniority – potentially making them attractive for income seeking investors.

The main risks stemming from Fixed Income Plans are first of all counterparty risk, in the event that the issuer becomes insolvent or defaults, a catastrophic loss could result. Then there’s market risk, observed at the end of the term when falls in the underlying over the term could lead to losses in the event the market drops below the protection level.

Fourteen pure fixed income plans have been issued in 2023 (by strike date), paying either monthly or quarterly income over terms ranging 3-6 years, with the majority utilising 5-year terms.

The Bank of England Base Rate commenced 2022 at 0.25% and consistently rose to reach 4.5% in May 2023. With the last two interest rate hikes of 0.25%, we are still unsure of how much further we have to go, especially with stubbornly high inflation. The chart below shows the improvement in annual income terms seen as the Base Rate rose throughout 2022 and so far in 2023, together with the coupons offered by fixed income plans.


BoE Base Rate vs Fixed Income Annual Rates

Whilst we can see that capital at risk fixed income terms have clearly improved since the start of 2022, with one three stock linked plan paying just shy of 9% per year in exchange for increased risk of capital loss at the end of term. In 2023 the trend of improvement has not persisted, with the majority of capital at risk fixed income plans now offering close to the 6% annual income mark.

Given the magnitude and speed of rate hikes, deposit-based autocall and income plans have emerged in competition with the capital at risk fixed income plans. So far in 2023 deposit autocalls has offered an average coupon of 6.4% for each year held, whereas the average income from capital at risk fixed income plans has been 5.9% per annum. Obviously, the income payments are unconditional whereas the autocall deposit returns are contingent on the performance of the underlying but this needs to be considered against the backdrop of the deposits not putting capital at risk from market movements or bank default up to Financial Services Compensation Service (FSCS) limits (currently £85,000 per claimant). Deposit-based fixed income plans have offered an average of 4.5% income per annum crudely demonstrating average risk premium of 1.4% per annum – a 31% uplift in return for putting capital at risk.

The effect of rising interest rates has had a clear impact on annual returns offered by income paying structured products. Given the significantly lower level of risk than a capital at risk plan thanks in part to FSCS protection in the event of counterparty failure, deposit-based plans have solidified themselves a place in the market, once again.

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