#Investments — 05.05.2017

Why Choose an Interest Rate Structured Product in a Context of Rising Rates?

Milena Ilcheva

In the wake of the 2007 subprime crisis, interest rates were historically low. Since mid-2016, the trend has reversed for two main reasons. Firstly, growth prospects in developed economies have improved significantly. Secondly, inflation has increased. The Federal Reserve has already raised its key interest rate to 1.00%. Meanwhile, the European Central Bank maintains its key rate at 0% but continues to reduce its monthly bond purchasing as part of its liquidity injection programme (the first step in the transition towards higher rates).

Against this backdrop, certain interest rate structured products may allow investors to benefit from an attractive return in the event of rising rates (a guaranteed return of at least the floor rate but not benefiting from any rise above the cap rate).


What is an Interest Rate Structured Product?

It is a Structured Product whose return profile is indexed to an interest rate.  Usually, this is a money market rate defined as the average interbank rate that large financial institutions charge on short-term loans. Central banks publish these rates on a daily basis in the press in a totally transparent way, so they are easy to find. Their maximum maturity is 1 year. These rates are very closely correlated to the monetary policies of major financial institutions. Each currency has a benchmark interest rate, the most popular being the 3m Euribor for euro-denominated loans, the 3m USD Libor for dollar-denominated loans and the 3m GBP Libor for loans in Sterling.

Examples of interest rate structured products

1. The "Cap & Floor"

The Cap & Floor is the most common product used with interest rates. It is a Structured Product with a protected capital at maturity that pays the investor a variable coupon equal to the benchmark rate. The coupon is paid regardless and benefits from a floor rate and a cap rate. Thus, the investor receives a guaranteed minimum return (equal to the floor rate) irrespective of the evolution of the benchmark rate. Conversely, the coupon paid cannot exceed the maximum potential return (i.e. the cap rate).

When buying a Cap & Floor, the investor seeks to protect his capital with a guaranteed minimum return (floor rate) by betting on a higher return in the event of a rise in the benchmark rate (up to the cap rate).

2. The "Slope Cap & Floor"

 The “Slope Cap & Floor” is a Structured Product with a capital guarantee at maturity. The investor receives a variable coupon equal to the spread between the 10yr rate and 2yr rate. Through this product, the investor bets on the steepening of the yield curve. Like the standard Cap & Floor, the coupon benefits from a floor rate and a cap rate.

However, like all other structured products, these investment solutions involve different risks that investors must be aware of. The product’s value may fluctuate depending on market trends, leading to a loss or a shortfall in income.

How to Analyse the Yield Curve Steepening    

Along with short-term interest rates (explained above), there are also long-term yields with a maturity of more than 1 year. These are obviously correlated to monetary policies but include other factors such as anticipated inflation and growth, the probability of seeing changes in key rates in the future, etc.

Interest rates on different maturities shape the yield curve. In a standard market configuration (economic growth, positive inflation), the longer the maturity, the higher the rate. This is logical because the longer the maturity, the greater the uncertainty, and thus, the higher the risk.

Generally, the yield curve steepening is defined as being the spread between the 10yr rate and 2yr rate.

Why Play the Steepening Today?

Yield curves (particularly in the US) are historically flat. For example, the spread between the US 10yr rate and the 2yr rate was 1.46% over the past 5 years. Currently, the spread is only 0.82%. We therefore expect the curve to steepen further, leading to a spread widening between the 10yr rate and 2yr rate. The “Slope Cap & Floor” would allow investors to benefit from any spread widening in the medium term.