Interest Rate-Tied Structured Notes May be a Good Play on Rising Yields in 2017

Interest Rate-Tied Structured Notes May be a Good Play on Rising Yields in 2017

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I have written many articles on structured notes on this website over the past several years and fielded a lot of questions from readers of the site about these notes.  These types of investments are not FDIC insured and ordinarily require a brokerage account with an investment bank like Morgan Stanley or Merrill Lynch to access.  Hence, they are not for everyone.  In fact, even for the most aggressive depositors and investors, they should only make up a small part of your portfolio.   But, against the indisputable backdrop of rising yields and a steepening yield curve in 2017, it is a good time to take another look at these types of notes.

The interest rate-tied structured notes that are most prevalent are ordinarily tied to US Constant Maturity Swap Rates.  The prospectus underlying these notes will always identify Reuters Screen ISDAFIX1 Page as the governing measurement, but the rates can be estimated by looking at the Constant Maturity Swap (CMS) rates at the bottom of this Federal Reserve webpage; the 2-year, 5-year, 10-year or 30-year swap is the difference between those CMS rates and the 6-month rate.

Interest rate-tied structured notes come in many different forms.  For example, banks can issue notes that are tied to the 3-month CMS or LIBOR that have a cap and a floor (i.e., trade between, say, 3% and 10%).  Just a few years ago, they issued notes that paid a fixed rate as high as 8% so long as the 6-month LIBOR stayed between 0 and 6%.   However, since the long end is likely to rise much faster than the short end of the yield curve, investors and depositors should look predominantly at two categories in 2017: those that are based directly on the 10 year CMS swap rate and those that are based on a spread between a short swap rate (either 2-year or 5-year) and the 30-year CMS swap rate times a certain multiplier (usually 4x or 5x for the 2-year CMS-based notes, and as high as 8x or 9x on the 5-year CMS-based ones).   There is always a second condition that notes will not pay interest for those days where an equity indices (usually the S&P 500 or Russell 2000) falls below a barrier level.  The barrier level is ordinarily 75% of where the index is trading on the day the notes are priced.   These notes ordinarily have a capped maximum interest rate that they can pay (between 9 and 12%) and often guarantee payment of that interest rate for the first year.  These notes are usually very long term in duration and are sometimes callable after the first year.

In a rising interest rate environment, these notes are likely to produce strong interest as determined at each reset date.   For example, those notes that are geared to the 2-30 CMS spread could easily get to their maximum capped interest rate as the spread gets to (and assuming it stays above) around 2%.  An interest rate around 8% to 10% will probably be a nice interest rate to make over the next few years as rates rise, especially as those in bonds begin to lose money quickly.   (Likewise, however, if we were to see an inverted yield curve, even one with much higher yields across the board, these spread notes could, in fact, yield nothing).

In addition to the interest rate risk, these interest-rate structured investments are not without other real risks.   We define three main risks, although there are many more.

First, there is credit risk.  These notes are tied to the debt of the issuing banks and are not FDIC insured.  While Morgan Stanley, Chase or Citibank are pretty good credit risks, so too was Lehman Brothers as we entered 2008.   Natixis, BNP Paribas, Societe Generale, Deutsche Bank and Credit Suisse are also big issuers, and while their notes can now be acquired at a discount, you should not be a purchaser of these notes at the moment unless you recognize and understand the credit risk that you are assuming.

Second, you have liquidity risk.  These notes extend out for very long periods of time, and if you (or your estate) need to get out of them, you are going to get hosed.  You can often benefit, however, from the hosing of others by buying notes through your broker on the secondary market.   Under any circumstance, you should recognize that you are never likely to be liquid quickly, and even if the interest rate play that you want to make materializes and your notes are callable, you could still be holding the notes in some distant interest rate environment that you cannot really foresee at the moment.  

Third, you have a risk of phantom income in the form of Original Issue Discount (OID) that your broker will be required to report on your 1099 by virtue of your ownership of these notes.  OID is determined largely based on the discount that the issuer sells the notes to your broker and an amortization schedule in the prospectus, and may substantially reduce the effective income of these notes in the first few years after the notes’ original issuance.  In order to fully understand the effects of OID on your taxable income, you will need to read the prospectus carefully and speak with your tax advisor.

Therefore, while interest rate-tied structured notes can be an effective way to generate yield in both a rising rate environment and a steepening yield curve, they are very risky and aren’t for everyone.  Even the most aggressive investors should therefore keep a portfolio that is much more skewed towards cash accounts and very short term CDs.

Note: There has recently been a large issuance of interest-rate tied structured notes that involve a return of principal of less than 100% if a second defined barrier level is breeched on the date of maturity.  For the same reasons that we strongly recommend that depositors avoid all equity-linked, commodity-linked and commodity-linked structured notes, interest rate-linked notes that do not guarantee 100% of principal at maturity should be categorically avoided in all circumstances.

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Getting Control of Your Out of Control Expenses

Getting Control of Your Out of Control Expenses

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Before you can ever begin to manage your money, you need to have a plan in place to help control how you spend it. It won't matter how much money you're earning if you're going to just spend it frivolously and not set up a proper budget. Here are some great ways to set up a budget to monitor and control how you spend your money so that you can keep track of it and better manage it.


Many who need to manage their money will learn that it just vanishes if they don't take the time to set u a budget. If you're not sure where you're money is going, you can't save it or keep track of it. So, the first thing to do is to create a budget. Your budget should track how you're going to spend your money, how you're going to save for things that you want to get and how you're going to do that on the income that you're earning.

Monitor Your Expenses

For the first several weeks, you need to record all of the things that you're buying as well as how much money you're bringing in. Keep track of every gas purchase for the car that you make, every coffee or soda that you purchase, every clothing item and anything else that you're spending your money on. You can track these on an Excel spreadsheet to see where you're spending it and where it's all going. You'll be shocked at how much you are truly spending on designer clothing or on coffee and soda. However, with some tweaking, you can wind up saving a lot of money and learn alternative methods to save money so that you'll be able to save for those things.

Cut Back Ties With Your Credit Cards

The truth is - if you can't pay cash for it, you really can't afford it. You'll have to learn to save money until you can buy what you want. Credit cards have all sorts of interest and you'll wind up paying back even more than you spent. By waiting, you'll actually be saving a lot of money and learning the age old technique of delayed gratification.

When you are ready to use your cards again, find the best travel and rewards sign up bonuses here.

Start Funding Your Retirement Fund

This is an important step that will help you to have a safety net for your future. You can use the plan at your job especially if they are willing to match what you contribute to the fund. You can also start your own fund. Your money should be deducted from your paycheck so that you'll be sure to save.

Be Frugal

Learn to live beneath your means. If you spend all of the money that you earn every month, you'll have none left - none for an emergency and none for fun. Instead, learn to live on the bare minimum and always set some money aside.

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Avoid Typical Money Traps

There are as many money traps as there are people. These pitfalls will soon part you and your money. If you're not careful you'll be broke so be mindful of the pitfalls and learn to save. Here are a few pitfalls to watch out for.

Gym Memberships

Don't be lured into a gym membership with a myriad of benefits. In spite of your best intentions, you're probably only going to go to the gym a few times per week and not the five that you've promised yourself. That few times will ebb into just once a week and eventually, you'll be at home thinking about that gym membership. Gym memberships are pricey and you'll need to see if you're really going to follow through or if it's a waste of your hard earned money. Give it a few tries before you invest in a gym membership.

Data Charges

Phone data charges can quickly add up. If you're not mindful you'll easily go over your limit and be charged more. Every time you check your social media pages, every time you check anything online, you're going to be charged. Soon, you'll be paying a small fortune for this service. Then there are the averages. These can add up even more quickly. Consider a plan that allows you to roll over what you're not using and let this add up.

Specialty Coffee

Ah, that delicious cup of coffee from the coffee shop. It's costing you a fortune. You may be paying more than it's really worth. In time, you'll find that you've spent a lot more of your budget on this than you realized. In just one year you could be spending over $700 on coffee at the coffee shop. Save it for a special treat and invest in a great coffee maker for the home that can deliver you delicious coffee in minutes. It's well worth the savings on coffee and the gas that you are using to get to the coffee shop.


We all love sales, but is it really a bargain if you don't really need it? Likely not. If you need the product and it's on sale, that’s great. But, if you aren't in need of the product and you're buying it anyway, that's not really a bargain. Ignore those flashy emails and sales flyers and save your money.

Home Repairs

Okay, there's not really anything wrong with home repairs, or sprucing up your home to make it look nicer. But, it's important to budget these things in and not buy them all at once and pay a fortune for them. Buy things a little bit at a time and focus on what you really need first. When you are sticking to a budget you'll feel so much better and you'll be able to buy what you really need when you need it instead of going deeper into debt. Once you master these steps you'll be more in control of your income and your expenses and begin to save your money.

If You Have $5 Million at Morgan Stanley, Merrill Lynch or JP Morgan, You Can Make $50,000 over the Next Year with 1 or 2 Hours of Work

If You Have $5 Million at Morgan Stanley, Merrill Lynch or JP Morgan, You Can Make $50,000 over the Next Year with 1 or 2 Hours of Work

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It is almost Labor Day and in the Hamptons the refrain at the end-of-summer cocktail parties is the same that we have heard all summer.

The refrain goes something like this:

“I’ve got $5 million in cash at Merrill Lynch.  It is earning me zero.  I don’t know what to do.  We may just elect in the very near future a truly unprepared and unstable President and the stock market is at an all time high.  I for one am not getting in now.  And, interest rates are at an all time low, so I cannot buy bonds.  My broker calls me and tries to sell me crap that neither he nor I understand.  I have no way to earn anything.”

The answer to this refrain is pretty simple.  At the moment, BestCashCow’s savings tables show that there are eight online savings accounts that currently pay at least 1% interest.  Depending on where you live, you may also find as many as another four or five local banks and credit unions servicing your market that are paying over 1%.   You’ll then find another eleven online banks - not including those banks you have already identified from the savings tables - that pay over 1% on 12-month certificates of deposit (CDs).

If you put $250,000 in each of 12 of so banks paying over 1% on savings accounts that are either online or in your market, you will put $3 million to work safely.  By putting another $250,000 into eight other banks that will give you over 1% in a one-year CD, you will be safely stocking away another $2 million.  Between now and next Labor Day, you will generate at least $50,000 that you would not otherwise make over the next year, albeit that money is fully taxable and the money in CDs cannot be accessed without paying an early withdrawal penalty.

There is a second Labor Day refrain in the Hamptons and it goes something like this:

“I cannot believe that I need to write another check for $45,000 to Horace Mann for my 12-year old’s tuition for next year.”

The answer to this refrain is also pretty simple.   By opening these accounts, you will generate much of the money to cover those annual tuition payments, even after you pay your Federal and New York State and City taxes.