Playing the yield: rates rev up structured products

Higher government bond yields and steeper forward curves fuel demand for new range of fixed income structures

Key points Summary Q&A

• Banks are touting structured products linked to constant maturity government bond yields, in a departure from constant maturity swaps.
• The appeal is improved payoffs as bond yields exceed equivalent swaps.
• Issuance has surged to an estimated $10 billion, led by the US and France where CMT and Tec10 fixings back products such as autocallables and range accruals.
• Yields on Phoenix-style autocallables linked to OATs are typically 1.5 to 2% above CMS-based versions, with coupons reaching 7%.
• However, many Tec10-linked autocallables have exceeded barriers as the 10-year yield rose to 3.58% this year, leaving essentially zero-coupon structures.

These summaries are generated by an LLM, but edited by humans.

Equities are typically the driving force for structured products. But rising rates have given a turbo boost to fixed income structured products.

First came reverse convertibles, callables, then range accruals and autocallables – all linked to constant maturity interest rate swap rates. But now issuers are touting products linked to government bond yields.

The difference in underlying fix might seem minor, but dealers point to a host of benefits including a clearer sell to investors and more attractive payoffs thanks to structural changes in the market.

Volumes have grown quickly, topping an estimated $10 billion. Activity is mainly concentrated in the US and France – countries that have ready-made indexes referencing constant maturity bond yields. But interest is expected to pick up further afield.

“Around two years ago, there was no normal trading on these,” says Nicolas Randazzo, Crédit Agricole Corporate and Investment Banking’s co-head of financial institutions structuring for Europe, the Middle East and Africa.

“Now we’re talking billions of euros of issuance and there are now between five and 10 dealers trading it. So the trend is really big,” he adds.

Like equity structured products, the fixed income versions need a reference point to determine payoff. The reference rate for these products has long been constant maturity swaps (CMS). But interest has shifted in the past 18 months to using constant maturity government bond yields instead.

1.5–2%

Yield advantage of Phoenix-style autocallable linked to Tec10 compared to one referencing CMS rates

A key driver is macroeconomics. Developed market economies have been issuing more debt to fund deficits as well as selling off central bank bond holdings, which has pushed yields on many government bonds higher than equivalent swaps.

Dealers report yields on a Phoenix-style autocallable referencing the French government bond index to be around 1.5–2% higher than one referencing CMS rates, with coupons regularly reaching 7%.

The other major draw is familiarity, banks say – yields on US Treasuries or French government bonds (OATs) are an easier concept for investors to follow than an esoteric swaps index.

Products linked to constant maturity US Treasuries (CMT) have found willing buyers in Swiss private wealth firms, while OAT products have been popular with insurers and retail customers.

Payoffs have focused on autocallables and range accruals so far. Interest has also developed in products where the payoff is the spread between the CMS and constant maturity government bond at the same tenor. Some banks have looked to recycle some risks to hedge funds, too.

German data provider Solactive has created several other constant maturity government bond indexes for countries such as Spain, Germany and Italy. The firm says it is also looking at baskets.

However, not all buyers have profited from the structures. Many autocallables referencing the French 10-year constant maturity rate, Tec10, have suffered because the yields on government bonds have exceeded the barrier below which the product pays a coupon.

Coupon barriers were typically set at around 3–3.5%. A year ago, the Tec10 stood at 2.91%. But parliamentary deadlock in the country and ensuing political paralysis have pushed the yield up to 3.58% as of December 8.

“There’s billions of investment in these essentially zero-coupon structures, because they’re not getting redeemed early,” says Adrian Bracher, head of fixed income structuring at UBS.

Yet, wider interest in government bond yield products should continue as long as the underlying dynamics of the government bond market persist, Bracher adds.

“It’s exceptionally niche currently, and time will tell. But I think we will have time, because that theme is not going to go away soon,” he says.

Rates revival

The post-Covid rise in interest rates was welcomed by structured note issuers as they could finally begin to compete with their equity colleagues.

Prior to that, with rates at or near zero, the market was effectively dead. With many products needing capital guarantees to appeal to investors, it wasn’t possible to do that and produce a coupon that was more attractive than what was available on the equity side.

But rate rises meant it was finally possible to offer coupons that rivalled equity – and with capital protection, unlike equity – and so banks started to issue notes linked to CMS rates. These rates, published by Ice, show the fixed rate on an interest rate swap at a given tenor, say 10 years, on a daily basis.

Among the first wave of products were short-dated reverse convertibles, with tenors of around a year, where investors receive their money back plus a juicy coupon if yields of a specific bond are below a barrier. If it’s above, they receive a fixed amount of the bond, which would tend to result in a loss.

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Investors looking for capital protection also looked to fixed rate callable notes, where the investor could gain coupons of more than 5% by selling the option of an early call of the principal to the issuer, after expiration of a preset non-call period.

“Suddenly, we could pay 5% or even higher on vanilla products. This was the beginning of a renewal in fixed income structured products after years of zero rates. As investors became used to receiving coupons of 5% or more, they wanted to pursue more yields and enhanced structures,” says Crédit Agricole’s Randazzo.

However, as rate hikes in the US and Europe paused and then reversed in 2024, Randazzo says vanilla callables started to pay less. In addition, some investors were unhappy that the timing of the call is up to the issuer.

But a falling rate environment also gives rates structured products an in-built edge over equity: mechanically steep forward curves.

Under the no-arbitrage principle, the forward price includes the cost of buying a bond at spot plus the cost of financing it in the repo market, minus returns from reinvesting the coupon payments in the reverse repo market.

With rates expectations falling, term repo costs have been low. Lower term repo reduces financing costs, which cuts the forward bond’s implied value and pushes the forward yields higher than spot.

For example, a 10-year forward on a 10-year US Treasury gives a yield of 5.71% as of December 3, compared to 4.68% for a spot 20-year Treasury, according to Bloomberg, using a bond stripping methodology. The difference between the two rates is more than double that of the same time last year.

 

Similarly in France, 10-year forward 10-year OATs were at 4.95% on December 3, compared with 4.03% for 20-year bonds – with the difference also around double versus the same time last year.

With the changes in the interest rate regime, structurers started to develop rates versions of the autocallable – the star of the equity structured products world.

Interest rate autocallables come in different guises, but broadly they give investors a healthy coupon if rates stay below a coupon barrier, otherwise the coupon for that period is zero. If rates fall below a lower barrier, the structure is automatically called and bigger coupons paid.

In essence, the investor is selling optionality to the issuer, and those options are priced off the forward rates. If the product pays out on rates going lower, but forward rates are priced artificially high, then selling that optionality generates more return.

That allows the issuer to set the barriers higher, giving more chance of the coupon being paid and the knock-out to occur, while still offering attractive coupons. The yield is similar to a fixed-rate callable and buyers have the added confidence of knowing when the product will be called, which is better for retail investors, says Samy Ben Aoun, head of continental Europe rates trading at Barclays.

He adds that fixed income offers stability and positive carry, while equities are trend-driven with negative carry. Together, they create complementary diversification through structured products.

“I like to ask people: which scenario has the higher probability – the S&P 500 dropping 30%, or 10-year US Treasuries yielding above 6%? Most assume the S&P drop, but market-implied probabilities actually favour the 10-year hitting 6%,” he says.

Seek and yield shall find

Bond yields make a better reference than swaps for these types of products, issuers believe. One reason is practical: clients easily understand how government bond yields work, compared to what could be seen as an esoteric interest rate swap rate. Historical data for constant maturity swaps is also not as widely available.

The main argument though is economic. Fixed rates on interest rate swaps are theoretically supposed to trade above yields on equivalent tenor government bonds, due to the counterparty risk embedded in the derivatives.

But as central banks have moved away from quantitative easing policies, which saw them buying up their own bonds in the market to inject liquidity into the system, this has flipped the positions.

Other structural factors have supported higher yields. For instance, as rates rise, funding ratios improve for firms like pension funds and insurers – meaning they don’t have to buy as many longer-dated bonds as hedges of their liabilities, resulting in upward pressure on bond yields.

In the US and Europe, bond yields trade higher than swap rates at longer dates – known as a negative swap spread – and the same goes for their forward rate cousins. The 10-year forward 10-year US Treasury yield for example traded at 5.7% on December 9, compared to the forward swap rate at the same tenor of 4.9%.

 

In Europe, given the CMS rate is a combination of the 27 eurozone nations, there are many opportunities within the individual government bond markets. France is the most popular example – 10-year forward 10-year OATs yield 4.95%, compared 3.52% for the forward euro CMS rate at the same tenor, as of December 3.

Therefore it makes sense to use the highest rate that gives the highest and most stable payouts on the structured products. Using these rates means coupons based on bond yields can be as high as 7% for an eight-year Phoenix-style autocallable linked to Tec10, compared with around 5–5.5% using CMS rates.

While there are still a handful of bond yield-linked products in the market that were created years ago, the first notes of the new era were printed in June 2024 by Crédit Agricole on the Tec10. One was a 10-year Phoenix done via a public offering, the other was a 10-year reverse floater done via private placement, which pays a coupon based on a fixed rate minus the Tec10 fixing.

 

Host countries

Constant maturity bond yield structured products have focused mainly on the two markets where there was already an index published by their respective Treasuries – France and the US.

Bracher at UBS says the most interest in CMT rates has come from private wealth clients, such as family offices, who understand CMT rates better than CMS.

“It’s a Treasury yield which is publicly available as a fixing and people can relate to that. And post-Covid, there’s been so much focus on interest rates and central bank action,” he says.

To get capital protection, Bracher says clients have opted for longer tenors, which have made range accruals popular. This product offers coupon payoffs to investors as long as CMT stays within a predefined range; if it’s outside that, they receive no coupon. Tenors have tended to be between 18 months and six years. The idea is to benefit from a range-bound environment.

Mostly they have been callable as well, which he says suits private wealth investors more than institutional investors.

“If your view is right, the bond gets called, you get slightly more yield. But for the institutional client, if their view is right, they want to benefit from the mark-to-market and restructure at the time, rather than just be redeemed at par,” he says.

Bracher believes around 90–95% of US CMT structured product volumes with private wealth have been callable range accruals. More recently, autocallables have gained popularity, specifically the Phoenix variety. This includes a memory function, which means if rates rise above the coupon barrier and the investor starts missing coupons, they can regain those lost payments if rates move back below it again.

We think that at least for the foreseeable future, CMT is going to continue to be major trend

Bhaavit Agrawal, Citi

Investors have also bought snowball structured products, which take the previous coupon at each period, add a spread and subtract the CMT rate.

Benoit Joffre, head of macro product structuring at BNP Paribas agrees the majority of CMT investors have come from private wealth, particularly from Switzerland but also from Asia and the Americas.

For products linked to France’s Tec10, the type of structure depends on the buyer. Joffre says retail investors prefer autocallables with tenors between five and 12 years, and non-autocall periods of usually one or two years.

On the institutional side, most interest has come from French insurers. Bhaavit Agrawal, head of markets issuance at Citi, says much of the institutional interest is in digital type payoffs, where the investor receives a coupon if the yield is below a barrier, otherwise there is zero coupon.

Range accruals without callability have also been popular, where if the Tec10 fixes between, say, 0–5% it will pay a 6–7% coupon. Some have also included quarterly observations of the range instead of daily.

Banks say there has been interest in inverse floaters linked to Tec10. French insurers, though, are close to full capacity with French exposure, says UBS’s Bracher. He says the bank has explored offering products linked to other government bond yields denominated in euro, but uptake has been low.

Index flex

Beyond France, banks say they have ramped up issuance on other countries’ bond markets. But as these countries typically don’t have a ready-made index like CMT or Tec10, they have looked to Solactive to create the indexes.

Baptiste Caen, vice president of institutional sales at Solactive, says the firm worked with Crédit Agricole CIB last year to develop a methodology for Tec10 equivalents, initially for Germany, Spain, Italy and Belgium.

That expanded to include the EU, Austria, the Netherlands, Portugal, the UK, Nordics, eastern Europe and Japan. The tenors have expanded beyond the standard 10 years, too.

“We have also started to have demand for baskets. So for example, 50% France, 50% Germany, or 25% each for Spain, Italy, France and Germany. They are quite correlated, but it all comes down to the country risk diversification,” says Caen.

Crédit Agricole’s Randazzo says they have traded on Italy, Spain, Germany and the EU so far, as an alternative for buyers who want to diversify beyond Tec10 products.

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Another payoff that has gained traction is on the spread between the CMS rate and bond yields multiplied by a leverage factor.

Forward curves for the spread between swaps and bonds at a given tenor are typically upward sloping due to term premium embedded in the bonds, and the demand for long-dated swap hedges from real money investors.

The products can be a useful way for insurers to hedge the asset swap risk they get from having their liabilities discounted at the swap rate and using bonds to hedge. This is especially the case for the less sophisticated players that are unable to trade the constituent parts themselves.

However, some dealers worry that spread products may present modelling problems. Typically, banks would build a term structure for the spread between the yields and CMS at a particular tenor, and identify a long-dated repo level. But this approach may prove difficult under the Fundamental Review of the Trading Book, the new market risk capital regime.

If banks want to use internal models to calculate their capital requirements under FRTB, as opposed to the regulator-set standardised approach, they have to pass a series of tests. One is that banks have to prove they have enough real price observations of individual risk factors to estimate price movements in stressed markets.

Risk factors that fall short are deemed non-modellable and face being capitalised with a stressed surcharge.

Risk transfer

Structured products issuance usually offers some risk recycling opportunities for banks, and the constant maturity bond yield products are no different.

Issuers of Tec10-linked products may choose to hedge with euro interest rate swaps. This exposes them to the basis between the two products, which in essence gives banks exposure to volatile France credit spreads versus the more stable eurozone.

Banks can stock up on OATs as a hedge instead, but as the product grows, may run into risk limits. So some banks say they have looked to offload the Tec-euro swap spread direct to hedge funds or technically minded pension funds.

Crédit Agricole’s Randazzo though says it takes time before the risk build-up is large enough that hedge funds would be interested in taking part.

“You need to get to a given size before it makes sense from an economic standpoint for both hedge funds and the bank to recycle risk,” he says.

Looking ahead, banks see further potential for growth for the product. “We think that at least for the foreseeable future, CMT is going to continue to be major trend,” says Citi’s Agrawal.

He says the next step might be the development of quantitative investment strategies referencing constant maturity bond yields.

Agrawal also points out that so far, products have been designed for investors bullish on bond prices, but that could expand to bearish structures in future.

Barclays’ Ben Aoun envisions a world where governments, which are looking for new investors to fund their increasing deficits, could even tap retail savers by directly issuing debt in structured product form.

“I think the path should be to democratise and give more access to these products,” he says.

Editing by Lukas Becker and Alex Krohn