MLCDs v structured notes: a tale of two wrappers

Sales of market-linked certificates of deposit (MLCDs) in the US have increased marginally during the first half of 2015, despite almost flat growth in issuance, with structured notes continuing to dominate the retail market.

The use of MLCDs by US retail investors has been low compared with structured notes over the last five years, although the wrapper has established itself in the market, with some of the leading issuers of structured notes such as Barclays, Goldman Sachs, HSBC and JP Morgan becoming increasingly active in this segment. Other companies, such as Choice Financial Solutions, have entered the market with technology platforms to allow financial institutions to efficiently and economically offer savings solutions to the mass market in a way that was traditionally reserved for only private banking.

Choice’s technology allows banks to use any kind of underlying and supports any type of payoff in their MLCDs, says Matthew Lifshotz, director, business development at Choice Financial Solutions, who believes products being sold via banks' distribution channels should be very vanilla types of products. “This may sound a bit boring for structurers, as they cannot get perhaps as creative as they would with structured notes,” he says. “But anything sold via the retail banking channel should be based on vanilla structures offering exposure to broad-based indices. We believe that the target customer for MLCDs is different to that of structured notes, and the products on offer in the two channels should be different.”

MLCDs are targeted at investors with a very conservative risk profile, says Fabrice Hugon (pictured), senior managing director of structured products at Elkhorn Investments. “These investors prioritise principal protection and use these products as an alternative to fixed-income deposits,” he says.

Elkhorn considers MLCDs a core product category because “they fit very well” with the company’s philosophy of developing new ideas and themes, and make them available to the wider market, says Hugon. “MLCDs is a wrapper that allows us to test ideas and new underlying assets in a safe way,” he says.

Incapital has seen demand for structured deposits overtaking that of structured notes. Within the accounts that the broker-dealer and distributor of structured products has partnered, there has been a substantial increase in MLCD demand, says Deryk Rhodes managing director, head of Incapital’s structured products origination & trading desk. “If we strip out lightly structured rate products (callable step-ups and fix-to-floats), MLCD volume is outpacing notes at a ratio of 1.8:1 year to date,” says Rhodes. “This is the first time since 2010 that MLCDs has topped note sales.”

Choice’s Lifshotz expects an increase in the use of MLCDs in the retail market but not at the expense of structured notes. “Investors in structured notes will continue to do so by using their financial advisers/broker dealers, as this is the best way to access this security wrapper to gain exposure to more complex underlyings and some capital at risk structures,” says Lifshotz. “However, we forecast that, in the retail banking channel, MLCDs are going to become more widely available to savers.”

Lifshotz stresses the importance of making a distinction between savers and investors, “as we strongly believe that banks seeking to secure their three- to five-year funding windows will use market-linked CDs to raise capital to satisfy their funding needs”.

The structured notes market is pretty crowded, says Hugon. “We don’t want to be just another wholesaler of S&P 500-linked notes. We don’t see room there to differentiate ourselves,” he says. “However, if we see value on a specific tactical investment, we would use the structured note wrapper as we did, for instance, when we launched our SPVO note.”

Elkhorn has developed a comprehensive offering (exchange-traded funds, MLCDs, notes, unit investment trusts, managed accounts) to be able to replicate some of its structures in different wrappers “to address the needs of different types of investors”, says Hugon.

Incapital’s Rhodes points out that, when looking at notional flows for MLCDs vs notes, it is important to distinguish between the different markets. “As a whole, demand for notes will almost always outstrip MLCD sales due to the size of the institutional and private bank markets,” says Rhodes. “Wirehouses, private banks and institutional investors tend to have more flexibility with regard to non-principal protected notes, shorter dated notes.”

Incapital focuses more in the regional broker dealer community and bank channels, “where there is more of an emphasis on capital preservation and FDIC protection”, says Rhodes.

According to Hugon, demand for market-linked CDs in the US market increased on the back of the credit crisis which saw a flight away from credit risk and increased demand for protection, but since then the US has seen a very significant rally in the equities market and that has translated into a risk-on approach from investors. “We see strong demand for growth structured notes with some capital at risk,” says Hugon. “Investors are happy to trade off protection for exposure to the upside and notes can provide this search for yield.”

In the low interest rate context, CDs would have to trade long-dated maturities whereas the structured note segment allows you to structure short-dated maturities and deploy opportunistic views, says Hugon.

Education remains a priority across the board for people to understand how they can use MLCDs in their portfolios, but there is also work to do from a promotional standpoint, according to Lifshotz. “MLCDs, when they are offered through the broker-dealer channel, are competing against non-FDIC (Federal Deposit Insurance Corp) insured structured notes, annuities and other products, and are not getting the interest they deserve because they are being sold through the wrong channel,” says Lifshotz. “MLCDs are saving products and should be sold via the bank’s commercial channels. We expect banks to take on this challenge and send a strong message to the market by selling the products they issue through their own distribution channels.”

Choice is working “in tandem” with some partners to promote this product to a new segment of the market and explain how they differ from structured notes and other products with “high embedded fees”, says Lifshotz. “We believe that savers can benefit from using MLCDs as they get exposure to the market but with added protections as well as reducing the embedded fees in structured products by 3% to 4%,” he says. “Choice does not distribute third-party MLCDs. We do not act as a brokerage firm as we provide the tools that allow banks to manage the entire life cycle of their core MLCD programmes which has the opportunity to be classified as core funding for the bank.”

Rates on fixed-income deposits are rising and that should provide opportunities for MLCD creators to provide attractive alternatives, says Lifshotz. “MLCDs are better suited for savers that want to achieve a return above the returns offered by fixed term deposits,” he says. “That’s where we see the value of MLCDs.”

Although the issuance of MLCDs has remained stable over the last two years, most players expect this issuance to increase if there is a bump in interest rates, but since CDs are not technically securities, a significant share of the issuance will remain below the radar.