Are Market-Linked CDs and Structured Notes In Banks Future?

Feature Article - Summer 2013 | By Andrew Singer

NOT THAT LONG AGO, market-linked CDs (MLCDs) were the ‘next new thing’ in bank investment programs. The MLCD share of program revenues seemed to rise each quarter, accounting for 5.1 percent of the bank-brokerage revenue pie as recently as the fourth quarter of 2011, according to BISRA.

Marc Vosen , Key Investment Services

[Like MLCDs, structured notes are essentially bonds linked to an index, like the S&P 500, but unlike MLCDs, they don’t carry FDIC insurance. One has to rely on the creditworthiness of the issuer, which need not be a bank. Notes can come with or without a guaranteed protection of principal.]

According to Vosen, when interest rates plummeted—and then stayed low—bank customers began to clamor for more yield and shorter maturities, which they couldn’t get with MLCDs. So KIS began to look at structured notes—albeit in a deliberate, cautious manner.

“It wasn’t a knee-jerk reaction. It was well thought out. We realized there was a whole different suitability standard, says Vosen. A client is now buying the debt of a corporation. [Consider only what happened to Bear Stearns and Lehman Brothers. If bank clients had purchased structured notes from those firms, there would be no federal government to bail them out.]

“There has been an increase in demand for structured notes in the bank channel,” says HSBC’s Scott Kerbel. It began in the fourth quarter of 2012, when more clients began to feel better about the equity markets. Principal protection became less important—at least for some client segments, says Kerbel, managing director-head of U.S. Retail Structured Products and Private Client Fixed Income, HSBC Securities (New York). He has seen a migration toward buffered notes (i.e., non-principal-protected notes), which was “not too dissimilar” to what happened in the wirehouses earlier (i.e., moving from MLCDs to buffered notes.)

‘These products are more and more mainstream, found in almost every large bank program. The business, including structured notes, should continue to grow.’ —Scott Kerbel, HSBC

Bank clients are increasingly willing to give up FDIC insurance for other features, more willing to accept some credit risk, says Kerbel, a different circumstance than, say, in 2008, with the economic crisis, when bank clients insisted on FDIC insurance coverage.

Recognizing that education is critical when it comes to structured notes, however, Key Investment Services developed three levels of training for advisors who would be selling the notes, including a FINRA training course, in-house training, and outside wholesaler training. The bank began with a single ‘notes’ vendor, although a second and third are coming on soon. The notes being sold have principal protection, but Key will consider selling buffered notes in the future, says Vosen. He recognizes that means introducing yet another suitability standard; they (buffered notes) are more appropriate for clients with a greater risk tolerance, in his view.

With regard to structured products generally, “The future is in non-principal protected [structured] products,” says Craig Brede, vice president, private investors product group, Goldman Sachs, speaking at BISA’s March conference in Hollywood, Fla. “It’s where the wrapper is most efficient.” The FDIC protection that comes with MLCDs is relatively expensive.

‘We need simpler product. MLCD products are [still] too complex,’ one reason the United States lags behind Europe and Canada in structured products. — Matthew Lifshotz, CHOICE Savings & Investments

Matt Lifshotz, IDEON

“MLCD products are [still] too complex,” one reason the United States lags behind Europe and Canada in structured products. All the talk of “caps” and “floors” and “baskets” is often too much for even intelligent bank customers who are not professionally involved in finance.

CHOICE, for instance, works with a large regional institution in the marketing of a three-year, binary MLCD product. If the S&P goes up after 12 months, the client gets a 3 percent return. If not, the client still receives his/her principal. At the 24-month period, if the S&P is still up (from the beginning of the contract), then the client receives 3 percent for the second year (otherwise just the principal). It’s the same with the final three-year period. If the S&P is still up after 36 months (from the beginning of the contract) you get 3 percent for the final three-year period.

The shorter duration MLCD—three years—is attractive to bank clients, says Lifshotz. Most MLCDs have five- or seven-year contract periods. But it is probably the relatively simple binary structure that is most attractive to customers.

Bank clients “are looking for investment alternatives that will outpace the growth of inflation, but they still won’t invest in products that they don’t understand,” comments Lifshotz.

What if interest rates rise?

The past 12 months have been “fairly challenging” for manufacturers and marketers of MLCDs given the low interest rate environment, notes Timothy J., Bonacci, president & CEO, CD Funding Group, LLC (Cincinnati), particularly with regard to constructing product. Banks and bank clients generally prefer MLCDs with five-year maturities, but those are hard to build when interest rates are so low.

With the recent rise in rates, we should see more MLCDs with five-year—compared with six- or seven-year—maturities, which should be a “good thing” for bank-sold MLCDs, says Bonacci.

Looking ahead, the critical variable for MLCDs in banks is not necessarily the interest rate environment, others suggest. Rather it is the lending appetite of banks. “What we care about is if banks want to lend money,” says CHOICE Savings’ COO Inigo San Martin. If they do, then the MLCD “is a good source of long-term funding.”

One structured product that has ‘gained in popularity significantly’ in banks the past year is a MLCD with a ‘dynamic structure.’ — Tim Bonacci, CD Funding

There are some signs this may be happening. “There is an uptick in lending now compared with a year ago,” observes Lifshotz.

In the future, “more and more banks will want to offer their own MLCDs,” says San Martin. Most large and even mid-sized banks offer MLCDs now, but these products are issued by HSBC or JPMorgan Chase or Bank of America or some other mega-institution. “These banks are reaching the conclusion that they are better off selling their own MLCDs,” a trend that should accelerate if and when lending picks up and banks require new funding sources. It’s his view that if banks issued their own MLCDs, many would sell three to five times more, volume-wise.

It’s important, too, that banks add MLCDs as a “catalog product,” that is, a core banking product like savings, checking, and traditional CD products, adds San Martin. Many banks still can’t offer indexed products on their core banking platform so they bypass this by creating, in effect, a financial security, and selling that on their brokerage platform. But this detour is one reason the United States trails Canada and Europe in distribution of structured deposit products, he opines.

One product structure that has “gained in popularity significantly” in banks over the past year, says Bonacci, is a MLCD with a “dynamic structure.” The product rebalances regularly. If its index basket is tied to equities, it might rebalance on a monthly basis, say. It’s almost like a mutual fund that rebalances among asset classes, but in this instance the work is done by an algorithm, not a money manager.

Which will prevail?

Scott Kerbel, HSBC

Still, caution is in order here. “Be careful,” says Larry Wilson, executive director, JPMorgan Securities, another panelist at the BISA March convention. “Don’t get into problems that will set the whole program back.” Structured notes are probably more suitable for larger banks—or at least those with more resources—because they require considerable education, and education is expensive, he suggests.

Regulators continue to scrutinize which structured products are the most appropriate options for clients, notes Bonacci. It’s not just maturities—five-year versus seven-year, say—but things like stock baskets on which the indexes are based. Some products may just be too complex for the more conservative bank B/D client. A 20-year product with a non-call in the first year that is tied to the interest rate yield curve may simply not be appropriate for bank clients. This remains a concern of both bank-owned B/Ds as well as regulators.

MLCDs can be a good, gradualist way to get into structured products, adds Wilson. Introduce ‘notes’ later. “If you open the floodgates too suddenly, it can overwhelm the platform, be too much for financial advisors.”

Goldman Sachs’ Brede doesn’t necessarily agree. It makes sense to start with both—MLCDs and notes—he says. He rejects the “mindset” that one is intrinsically safe, the other risky. After all, mutual funds and equities don’t have guaranteed principal, and they are sold in banks. (That said, Goldman Sachs doesn’t favor one or the other, and is looking to do the best thing for that investor, whether it be structured notes or CDs, a company spokesperson later told us.)

In any event, the lack of FDIC protection doesn’t mean structured notes are more complex than MLCDs, according to HSBC’s Kerbel. “Structured notes are often simpler” and often come with shorter maturities, he says. Nor are they inherently more risky. Indeed, the payoff methodology with buffered notes is often easy to grasp.

‘It wasn’t a knee-jerk reaction. It was well thought out. We realized there was a whole different suitability standard’ for structured notes. — Marc Vosen, Key Investment Services

Tim Bonacci, CD Funding

Andrew Singer is editor-in-chief and publisher of Bank Insurance & Securities Marketing magazine. He can be reached at asinger@bisanet.org