Structured notes: How can banks support investors in a zero-interest rate environment?

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Japan’s retirees have long experience of the zero-interest world that’s established itself across Europe and the US. Yet despite no or minimal yields, an aging population manages to get some income. How are they putting they money to work?

For decades now, the Japanese have been able to access higher yields by running foreign exchange exposure. What does this mean? Banks that need to raise funds have been offering high-yield uridashi bonds that are linked to emerging market currencies to the retail market in Japan. These bonds carry the risk of the emerging market currency (hence the high yield), but without these markets’ credit risk as the issuer is usually a reputable Bank, with high credit rating.

Here’s how it works: Let’s assume that South Africa has rates around 7%. Large development banks with high credit ratings can issue bonds that are denominated in ZAR (South Africa Rand) and pay high coupons, but the interest rate payments are converted to JPY (Japanese Yen) and paid in JPY, so the Japanese investor can get JPY on their checking account.

Let’s assume that today’s FX rate means 10 JPY buys 1 ZAR and rates in South Africa are 7%. The World Bank can then issue a 5-year note, worth 100 ZAR, that pays 7% a year, paid annually, for 5 years.

With the FX rate at 10 JPY for 1 ZAR, the Japanese investor that buys this ZAR 100 note will pay JPY 1,000 for it. If the FX does not change, the 100 ZAR worth of the note gets JPY 70 a year and JPY 1,000 back, compared to getting 0.1% (or 1 JPY) on a standard JPY 1,000 investment.

But FX moves around, usually not in favour of the local currency. If the currency devalues 100% (1 ZAR now buys 5 JPY), the investor still gets JPY 35 a year (7 ZAR x 5 JPY per ZAR). At the end of the term, the ZAR 100 is converted back to 500 JPY, leaving the investor with a total of JPY 675 for their JPY 1,000 investment (500 of principal + 5 times x 35 interest). This may not sound like a great return. But with ZAR devalued like this, local interest rates are likely to be higher, say 12%. So, at maturity, our investor uses their JPY 500 to buy another ZAR-denominated note worth ZAR 100, which pays JPY 60 a year with rates at 12%. The investor’s yearly income is now 60 JPY, bellow the original 70 JPY, but still much better than investing locally at 1 JPY income per year.

This is called “coupon clipping.” It means investors don’t need to deplete their savings to survive, but instead use interest income. Unlike what one had in the past in developed countries (investors in the US buying tax-free municipal bonds, as an example), this type of investment means the principal is at risk. With ultra-low interest rates and ageing populations, Europe and the US might start to see this type of investor behavior.

But what about regular high yield corporate bonds? We have seen a massive pick-up in corporate bond issuance, as corporates need cash and banks are not keen to increase their credit exposure. Supply is there, but if the demand is higher, credit spreads will be moving lower and the return on these will get lower and lower. Have any doubts about people chasing returns? Check the stock market…

So as the supply of corporate bonds dwindles and rates remain low, I would not be surprised if financial institutions start to offer bonds similar to uridashis to retail investors in places like US, UK and EU. If high-street banks don’t pick up on this opportunity, the floor will be open for big tech companies to step in.

The race, therefore, is on. Retail banks have a good head start, as their customers are “sticky” and slow to switch. But with fintechs steadily picking off business, it’s clear that this stickiness has its limits. How can banks take advantage of this trend – if (or when) it happens – and defend themselves quickly and without massive investments?

I believe platforms provide the answer. Using a platform like, banks don’t need to reinvent their product lines: they can simply link up with companies carrying out new issuance on behalf of development banks and offer products directly. Whether you call it “primary issuance as a service” or “high yield bonds as a service,” it’s also a way to transfer risk effectively, as the banks’ role is simply to bring products directly to clients.

Will this scenario come to pass? If we are lucky and equities are showing the way (and not only being pumped up because of the excess liquidity in the system), then pent-up economic activity will take off and inflation will be back, and with that you will get back bonds with proper interest income. But if zero-interest rates are here to stay, being able to leverage high yields in emerging markets may give an opportunity for banks to offer a great product to their clients as long as banks have the platforms and partnerships in place to take advantage.