With this in mind, we believe that structured investments with full downside protection at maturity, such as market-linked certificates of deposit (MLCDs) and market-linked notes (MLNs), continue to offer improved capital preservation characteristics, as well as a recovery in return compared to short-term bonds.
What are Market Linked Notes (MLN)?
Like traditional bonds, market-linked notes (MLNs) offer a return of principal at maturity. Unlike traditional bonds, MLNs do not pay a fixed rate of interest. Instead, they provide a rules-based payout, with the payout at maturity tied to the performance of a selected underlying index over a specific time horizon. Maturities of 2 to 5 years are common and MLN returns are often based on the performance of an underlying equity index.
Here are some indicative terms for an MLN available in the market at the time of writing (subject to change at any time):
- Structure: Market related note
- Maturity time: 5 years
- Underlying index: Dow Jones Industrial Average (DJIA)
- Participation in the decline: Full capital protection at maturity
- Upside participation: 110% of the price return of the Underlying Index at maturity, subject to a cap of 70%
The benchmark for this theme is a 5-year Treasury. With a starting yield of 4.3%, we expect a held-to-maturity 5-year Treasury bond to offer a five-year yield of around 23%. The exact return will depend on the interest rate environment in which the bond coupons can be reinvested; if returns increase, this will improve the return on any reinvested income; but if they fall from here, it will reduce the total return of the treasury investment.
Historically, a structured investment with the conditions described above would have generated a return of over 23% – beating the 5-year Treasury benchmark with a current yield of 4.3% to maturity – on around 63% of all rolling 5-year periods since 1926. The note would have produced an average return of 38% (6.6% per year), receiving the maximum gain (70% or 11.2% per year) on approximately 28% of all historical 5-year performance periods.
It is possible that this historical analysis underestimates the chances of the theme outperforming. The DJIA is already more than 10% off its last all-time high; historically, this would have improved the chances of a high return over the next five years. Additionally, we expect bond yields to fall over the next five years, which would slightly reduce the yield of the benchmark 5-year Treasury. Together, these factors slightly improve the likelihood of an MLN with these conditions outperforming a 5-year Treasury from here. On the other hand, the theme carries three main risks: a bear market, issuer default and liquidity risk.
We believe that MLCDs and MLNs are particularly effective as part of a bond ladder in your liquidity strategy, where assets are reserved for spending over the next 3-5 years. The liquidity strategy is designed to help you meet all portfolio cash needs for the next 3-5 years. For this portion of your wealth, the primary objective is capital preservation, with return being a secondary consideration. For more information, see Liquidity Strategy: A Rising Tide Raises All Yields.
For more information on the UBS Chief Investment Office’s implementation recommendations and details on the theme’s performance to date, please read the full report: Theme Update: Improving Liquidity Strategy Return Potential with MLCDs and MLNs.
Main contributors: Leslie Falconio, Michelle Laliberte, Daniel J. Scansaroli and Justin Waring
Read the full report Thematic Update: Enhancing Liquidity strategy return potential with MLCDs and MLNs, November 10, 2022.
This content is a product of the Chief Investment Office of UBS.
UBS Wealth Way is an approach integrating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our financial advisors can use to help clients explore and pursue their wealth management needs and goals over different time periods. This approach is not a promise or guarantee that wealth, or financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment. Deadlines may vary. Strategies are subject to each client’s goals, objectives and relevance.