This unusual asset can bring value when investing on a fixed income

Want to know my unpopular opinion on the fixed income market? It is more difficult for active fixed income managers to outperform today than it was five years ago.

As a reminder, there is an inverse relationship between the direction of interest rates and the value of a bond. Five years ago, when the 10-year Treasury yield was at 0.6%, owners of 10-year Treasury notes were betting interest rates would continue to decline and the value of their bond portfolios would continue to rise. Unfortunately for them, the opposite occurred, and fixed income investors endured some of their worst returns in a long time.

With the 10-year Treasury yield now above 4%, many portfolio managers are pleased there is finally yield in fixed income. At Paragon Capital Management, we believe today’s environment continues to call for an expanded menu of nontraditional investments to outperform. These nontraditional investments can replace all or a portion of a fixed income portfolio. Callable yield notes are one of our most utilized nontraditional investments.

Callable yield notes are senior unsecured debt obligations issued by large international investment banks. A callable yield note is a hybrid security combining a fixed income security with one or more derivative components. These notes offer income plus return of principal if the value of the underlying assets remains within a specified range during a specified period.

The underlying assets can be indexes, individual stocks, currencies or commodities. When a note is created, the investor determines the level of risk with which they are comfortable, and a downside barrier is agreed upon and set. The barrier level is used to determine whether or not the investor will receive the expected income payments and the percentage of principal returned at maturity.

Here are examples of callable yield notes we structured for clients in July 2025:

The first example is a two-year note that is callable every three months by the issuer. It has a coupon rate of 12% and it was issued at par (no premium or discount). The barrier is 70% (30% downside protection). The underlying asset is the worst-performing index out of the S&P 500, Russell 2000 and EURO STOXX 50.

If none of these indexes are down more than 30% from the trade date, the investor gets their coupon payment every 90 days, the observation period. If at the end of a 90-day observation period any of the indexes are down more than 30%, then the investor misses that coupon payment and moves on to the next 90-day observation period. If all three indexes are higher than they were on the trade date, then the bank has the option to call the note at par and pay that quarter’s coupon payment.

If none of the indexes are down more than 30% at maturity, the investor gets the last coupon payment and the return of their original investment. If the worst-performing index is down more than 30%, the investor loses that portion of their principal. If the worst-performing index is down 40%, the investor loses 40% of their principal.

The second example is a three-year note that is callable every three months by the issuer. It has a coupon rate of 9.15% and it was issued at par. The barrier is 55% (45% downside protection). The underlying asset is the worst-performing index out of the S&P 500, NASDAQ-100 and EURO STOXX 50.

The same rules apply to this example as the first example. The investor received a lower coupon rate in exchange for a longer investment period and increased downside protection.

Coupons on callable yield notes vary due to a number of factors, including current interest rates and the level of the CBOE Volatility Index (VIX). The VIX measures expected market volatility using a portfolio of options on the S&P 500. Investment risk can be reduced by laddering maturity dates as well as using different barrier levels, indexes and issuers.

Jamie Cinotto is the Director of Institutional Sales at Paragon Capital Management, LLC. Paragon provides investment professionals with custom-built investment solutions for their clients.

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