Fixed Coupon Notes are a type of equity-based structured security that provides regular income payments (coupon payment) regardless of market conditions.
This fixed payment lets it function similarly to a fixed-income product like a bond.
The equity base also gives it more upside potential, and the contract gives the investor additional downside protection.
Fixed Coupon Notes can offer a reliable income stream and can capitalize on market volatility, making them an attractive alternative investment in rising interest rate environments.
They provide a predictable income stream through coupon payments, which can enhance returns in negative market scenarios and enhance returns with the underlying equities.
Let’s take a more in-depth look at fixed coupon notes.
Contents
What Are Fixed Coupon Notes (FCNs)
As discussed above, fixed coupon notes are a structured investment product that combines some of the benefits of bonds and equities.
These notes are structured to have a basket of securities (most often equities) as the underlying instruments, and those determine how profitable the fixed coupon note is at the end of the contract.
These notes provide fixed payments at set intervals, attractive to income-seeking investors, and provide market exposure, which is attractive to growth investors.
One large benefit is that market fluctuations do not affect the coupon payment.
These coupon payments also help to offset some of the possible downsides in the equities, which is where the protective aspect of the Note comes in.
This makes them an effective investment tool for investors looking to add equity exposure and manage risk.
When the contract is done, the outcome of the Note is dependent on the equity that performs the worst in the basket.
This is called the Least Performing Equity (LPE) and will be discussed more below.
The two most common outcomes of the fixed coupon note are that the investor receives their principal back and gets to keep the coupon payments, or the least performing equity did not meet its minimum requirement and must be purchased by the investor.
A Deeper Look At Fixed Coupon Notes
Now that you are introduced to fixed coupon notes let’s examine the nuances of these financial instruments a little deeper.
FCN Terminology
Let’s take a look at the terms used with Fixed Coupon Notes.
They are a little different than when they are all used in their typical settings.
Principal – The amount of money invested in the Note
Coupon Rate – The annualized percentage paid to investors on the principal regardless of market fluctuations.
Coupon Interval – The frequency of coupon payments
Term – The length of time the fixed coupon note is active.
Initial price – the price of the underlying equities when the contract is started. This is represented by 100% in terms of the price events below.
Knock-In price – The percentage below the initial price and the strike price where the Note is terminated and the least performing equity is automatically assigned to the investor.
Knock-Out price – The percentage below the initial price where the contract is terminated and the investor is paid out their principal plus any accrued coupon payments. This only applies to the least-performing equity.
Strike price – The price, or cost basis, used when shares of the least performing equity are assigned to the investor.
Least Performing Equity – The stock in the initial basket of underlying securities that performs the worst over the contract period. This is the equity any actions are determined by when a contract term expires.
Final Fixed/Fixing Level – The closing level of the underlying stocks in the basket.
Familiarity with these terms will enable you as an investor to make the most informed decision possible about any Fixed Coupon Note you enter.
How Do FCNs Work?
Fundamentally, these notes are directional trades based on the investor’s views on the underlying security.
The Note provides additional security and cash flow, making it an attractive investment vehicle.
These notes also have a time and financial component akin to options, adding another level of complexity.
When a fixed coupon note is created, there is a strike price, a knock-in level, and a knock-out level.
These represent prices in the underlying (expressed as percentages) that cause the Note to execute an action automatically.
If the basket’s price is above the strike and knock-in level at the end of the contract, then the Note expires, and the investor receives their principal back plus all the accrued or paid coupon payments.
When the price moves above the knock-out level, the contract is closed early, and the same thing happens: the investor is paid out.
If the price falls below the knock-in level, the contract is also closed, but shares of the company that fell below this level are assigned to the investor at the strike price.
Benefits Of Fixed Coupon Notes
There are several key benefits to Fixed Coupon Notes, many of which were already touched on in other parts of this article, but here we will go into detail about them.
One of the primary benefits of FCNs is their fixed coupon payments, which provide investors with a predictable income stream regardless of the underlying.
This feature makes FCNs attractive for investors seeking stable returns in uncertain market conditions.
The second benefit is that, depending on how they are structured, fixed coupon notes can benefit from market volatility and growth, allowing investors to make additional gains from appreciation of the underlying.
Finally, these notes are helped by increasing interest rates. An investor can receive a maximum annual yield when the Note is set up.
As rates increase, payouts are pushed more into the investor’s favor.
Drawbacks Of Fixed Coupon Notes
Fixed coupon notes are not without risks and drawbacks, though.
One of the primary risks associated with FCNs is the possibility of a 100% loss of principal if the underlying securities significantly underperform.
While this is not likely, it is possible, so choosing the equities for the fixed coupon note is important.
Another drawback is that investors have limited returns compared to direct investments in securities.
If the underlying securities take off, the gain on the investment is limited to where the knock-out level is set.
While there are only two main drawbacks, these are both serious and should be considered before entering into a fixed coupon note.
Many other investment products may be better suited to your needs.
Example Of A Fixed Coupon Note
Let’s now look at an example of a fixed coupon note in action.
An investor has $100,000 they would like to invest into a fixed coupon note.
They have a basket of 3 stocks they want you to use: A, B, and C.
The strike level is 93% of the initial, the knock-out level is slightly above 98%, and the knock-in level is 90%.
The term for this contract is nine months.
If all the stocks finish between the knock-out and knock-in levels, the investors will receive back all their principal and accrued interest payments.
If the least performing is under the knock-in price at expiration, the investors will receive their accrued interest payments and the shares instead of the principal.
This example highlights the potential benefits and risks associated with FCNs, demonstrating how they can provide a fixed income stream while managing risk.
This highlights the importance of selecting strong stocks for any fixed coupon notes to include in the basket.
Conclusion
Fixed coupon notes offer a unique investment opportunity, providing a reliable source of income and access to potential growth.
By understanding the structure and benefits of FCNs, investors can effectively use them to diversify and potentially de-risk their portfolios.
As a structured instrument, fixed coupon notes combine the benefits of bonds, equities, and options, making them attractive for investors seeking predictable returns.
With their fixed coupon payments, FCNs provide a safeguard against market volatility, ensuring a stable annualized yield.
We hope you enjoyed this article on fixed coupon notes.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
