Decrement Indices – An Introduction

Introduction

"Decrement indices" have become increasingly common underliers in the European and Asian structured product markets.  However, although their use is increasing, they are somewhat less familiar to an American audience.  In this article, we summarize the structure of these indices and how they are used by product manufacturers and investors, and address some of the risk factors that investors face when investing in a structured product linked to these indices.

Decrement indices have been particularly popular underliers in a low interest rate environment, as they can be used by product manufacturers to offer somewhat higher returns.  Issuers can use decrement indices to offer product terms that are more favorable to investors, since they can be structured to reduce the issuer's "dividend risk,"  as discussed below.

What Is a "Decrement"?

A decrement feature can be applied to most types of equity indices. The index is established by creating a total return variation of the index, and modifying that index by deducting a specified dividend from the level of the index on each trading day.  (This deduction may be referred to as a "synthetic dividend.")  The deduction of this fixed decrement from the total return index is intended to make the index comparable to the “price return” version of the relevant index (that is, a version of the index that does not include the reinvestment of dividends), but with a deduction of a fixed decrement from the total return instead of a deduction of the actual dividend yield on the relevant stocks. The hypothetical level of dividends of the relevant stocks are determined in advance and are fixed for the life of the index, and may of course be higher or lower than the actual dividend rates.

In general, a decrement index will outperform the price return version of the index when the actual index dividend yield equals or exceeds the dividend yield contemplated by the decrement index.  However, a decrement index will underperform the price return version of the index when the actual index dividend yield is less than the dividend yield contemplated by the decrement index. While the investor bears the risk of this underperformance, the potential of a higher return on the offered securities may be attractive to an investor.

The decrement feature is a mathematical calculation, and it can be applied to most types of equity indices – standard market indices (both U.S. and non-U.S. stocks) of large or small market capitalizations, indices that apply an alternative weighting plan to these indices, sector specific indices, "ESG" indices and proprietary indices used by product manufacturers.  In fact, a decrement index can be created out of a single underlying stock, tracking its total return performance, but reduced by the synthetic dividend.

Decrement Index Variations - Fixed Percentage Deduction vs. Fixed Point Deduction

Decrement indices typically use one of two different methodologies to deduct the synthetic dividend: (a) a fixed percentage deduction or (b) a fixed point deduction.  In the fixed percentage deduction, a specified percentage of the index return is deducted daily.  In the fixed point deduction, fixed index points are deducted from the index level.  As a result, in each case, the return on the decrement index each day, will diverge from, and be lower than, the total return version of the index by the amount of the daily decrement.

The fixed percentage method is often used in situations where the dividend yield remains stable over the long term. Dividend discounts on indices with fixed percentage decrements often track the long-term historical averages of the index's dividend yields.  In contrast, a fixed point deduction method attempts to capture the constant level of dividend amounts over the short term, since many companies maintain a consistent dividend policy relative to their earnings in the short-term. In the case of the fixed point deductions, the effective percentage deduction at the index base date, which is computed by dividing fixed points by the initial index level, is usually established to match a recent realized dividend yield.

In terms of potential performance, all other things being equal, a fixed-point decrement index will outperform a fixed percentage decrement index when the markets rise, because the deduction of the fixed points has a smaller impact on the total level of the index.  However, the fixed point decrement indices will underperform the fixed percentage index in a falling market.  That is, a fixed point deduction will reduce the level of the index to a lesser extent when the level of the index increases, but will reduce the level of the index to a greater extent when the index decreases.

How Do Decrement Indices Compare to Other Indices?

Here, we compare decrement indices to other key types of indices:

• Price return index: dividends are essentially ignored in the index calculation, and the level of the index reflects only the trading prices of the index constituents.
• Total return indices: dividends on the index constituents are deemed to be reinvested across the index constituents, without any deduction for withholding taxes.
• Net total return indices: dividends are deemed to be reinvested proportionally across the index components, after giving effect to a deduction for hypothetical withholding taxes.  This type of index is intended to represent the returns of a hypothetical investor that holds the index constituents, and reinvests the dividend payments after deducting the relevant withholding taxes on the dividends received. 

In contrast, a decrement index is based on a total return index or a net total return index, reducing the performance of that index by the synthetic dividend amount. The decrement index will always underperform the applicable total return index or the net total return index, due to the deduction of the synthetic dividend. Similarly, where a decrement index tracks the performance of a single component stock, the decrement index will underperform a direct investment in that stock, because the direct investment would benefit from dividends paid by the stock without the deduction of the synthetic dividend.

Why Do Issuers Use These Indices?

When an issuer links a structured note to an index, it (or its hedging counterparty) will often hedge its obligations in part by purchasing assets linked to the underlying index, such as an ETF that tracks the index, or by purchasing the constituent stocks.  As a result, the issuer is "long" the dividends on the index, and faces the risk that the dividends on the index will decrease over the term of the relevant notes.  In such a case, the issuer's returns relating to the issuance could be significantly reduced.  By using a decrement index, the issuer reduces the economic risks arising from lower dividend levels – the bank will make payouts to investors based upon the actual dividends that are paid on the securities that the bank owns to hedge its risk less the synthetic dividend, thereby reducing the volatility of the issuer's expected returns due to changes in the actual dividend levels.  If dividends are lower than the expected dividend level, the payout on the notes will reflect, and be reduced by, the higher amount reflected in the index's synthetic dividend.

Risks to Investors Arising from Decrement Indices

Depending on whether the fixed synthetic dividend embedded in a decrement index is greater than or less than the actual dividends on the relevant index stocks, the decrement index could underperform the related price return index.  If the actual dividends on the underlying index are less than those of the synthetic dividend incorporated into the decrement index, the investor's return are expected to be lower than the price return version of the index. A decrement index will always underperform the total return version of the index, due to the deduction of the dividends.  Similarly, as discussed above, the selection of a fixed percentage decrement as opposed to a fixed point decrement could reduce an investor's return. Accordingly, market participants may wish to carefully reference an index's historical dividend yield, and the specific structure of the index, when considering whether to issue or purchase a decrement index-linked product.

Authors: Lloyd Harmetz, Partner and Evan Hillman, Counsel.