Flip-flop products – the rise of callable fixed income structures

The main effect that has been seen in every country is the increase in capital protected products compared to three years ago. This is because higher interest rates lowers the cost of capital protection and leaves enough value for equity linked upside potential. As a result, there has been a significant increase in capital protected digital and participation products.

We can define a flip-flop to be any product with fixed income combined with either floating rate or equity returns 

Another noticeable change has been the number of simple fixed income products made possible by higher rates. Many investors are now perfectly happy with cash deposits that earn 5% or more with no risk to capital (except through counterparty exposure) and therefore have less need to consider structured products. In order to provide extra yield fixed income callable products have emerged recently. These callable products act like cash deposits except for a variable maturity at the issuer’s discretion.

The rise in interest rates has also generated enough interest in the structured products sector to create a set of products that play with combinations of fixed income, floating rates and equity returns. This product set is known as the “flip-flop” and many such examples already exist on the SRP database accessible at SRP.com.

We can define a flip-flop to be any product with fixed income combined with either floating rate or equity returns. It is because interest rates are higher that such combinations become possible as with rates at levels around the two percent mark there is not the flexibility or headroom to provide such variation.

Additionally flip-flop products tend to be capital protected as they focus on income variation and as we have already observed capital protection has only recently become truly viable again. 

The first example (SRP ID 40791859) was issued by BNP Paribas in France in May 2023 and is linked to the Euribor three-month rate. The first year the product pays 2.95% fixed quarterly and the second year a fixed rate of 3.25%. For the remaining years the coupon is linked to Euribor floored at three percent and capped at four percent. At the time the product was launched the risk free Euribor rate was just under three percent . The coupon stream offered has rising yield rates and potentially offers up to four percent. The flip-flop product type can position itself to take account of further interest rate movements during the lifetime of the product.

The second example (SRP ID 39796727) was issued by BNP Paribas is linked to the constant maturity rate of EUR. The coupon for the first two years is 5.5% p.a. thereafter the coupon is given by twice the CMS 30 year minus two-year spread. However, the product has an auto callable feature which terminates the product at 100% once the total coupons paid reaches the 12% limit. Given that 11% is paid out fixed it amounts to a leveraged bet on future coupons dictated by the shape of the yield curve. The investor is hoping for a quick maturity and has the assurance of capital protection but does not want the product lasting to the full six-year maturity because this would automatically mean that very little extra income would have been paid. This product payoff is rather complicated and likely to confuse some investors.

The next product (SRP ID 39635190) is issued by Société Générale in France and pays 5.3% for the first five years and then 4 times the spread of 30-Year minus 5-Year CMS. The issuer can call the product after five years which will happen if the long end of the yield curve rises relative to the shorter end and so calling will occur rather than pay higher coupons. Even in these circumstances the investor is guaranteed full capital return and income rates and the opportunity to reinvest at prevailing rates which are likely to be higher.

The final example (SRP ID 15885014) was from the Belgian market in 2017 and combines equity upside linked to the Solactive European Deep Value Select 50 index. This index invests in value European stocks that generally have a high yield. The maximum maturity was eight years and if it runs the full period will be 100% participation in an equity average rate option. However, the issuer can convert into a fixed coupon of five percent p.a.

This is essentially a variant on the autocallable construction by offering a fixed return rather than let the product run but is converted into income to turn into a high yielding investment.

In summary the flip flop represents different ways to combine or alternate fixed and floating rates to play future rate movements or offer yield levels now made possible by rising rates. 

Image: Bits and Splits/Adobe Stock.