Structured notes can offer investors protection when markets are volatile
The large market swings over the past two weeks have been tough to stomach for retail investors and seasoned pros alike, but what makes them especially challenging is that the type of trading occurring is being primarily driven by central-bank speculation.
Take last Tuesday's 4.3-percent correction in the S&P 500. It was not only the largest oneday drop since June 2020, but the lowest average volume for a sell-off of its size since 2018, according to Bloomberg. The cross-asset correlation from stocks to bonds to commodities as tracked by Barclays PLC also showed readings that ranked among the highest since 1981.
This means investors are going to have to be patient and expect more of these large low-volume moves, at least until signs appear that the United States Federal Reserve is going to pause its rate hikes, as indicated by factors such as core consumer price index reports.
Being patient can be a difficult thing in these kinds of range-bound, volatile markets. But there is one strategy we've been deploying that we think offers an excellent alternative to both stocks and bonds that are moving together in this central-bank-driven market.
Structured notes are a stock/ bond hybrid because they are a debt obligation issued by a bank containing an embedded derivative component that results in a coupon payment linked to the performance of a particular index, exchange-traded fund or even basket of stocks.
There are many different note strategies, but they commonly offer varying amounts of downside protection compared to simply owning the market outright. The upside participation is often limited to just the coupon payment received, but can be very attractive in this low-rate, range-bound environment, with yields ranging from five to 20 per cent.
For example, we recently participated in a callable income note on the Canadian banks. It will pay an annualized 9.54-percent coupon on a monthly basis contingent on the Canadian banks not falling more than 40 per cent from current levels. Keep in mind that many have already fallen 15 to 25 per cent from their April highs.
If they fall more than 40 per cent, you simply miss the coupon payment that month, but it will be paid again the subsequent month if the banks are above the negative 40-per-cent threshold.
At the end of the seven-year term, assuming it doesn't get called away beforehand (it has a call feature at 105 per cent), you get all your money back as long as the banks are not down more than 40 per cent (which has never happened before) plus the contingent coupons along the way.
Overall, we're currently running 30 to 50 per cent of our client portfolios in notes, some of which have been custom built for us by the capital markets groups at the Canadian banks. This way, we can design them around our outlook and include equity indexes such as the S&P/TSX composite and S&P 500 or even particular segments like agriculture, technology, materials, banking and energy.
It is important to know that notes can have sales commissions ranging from 2.5 to four per cent bolted on, but we always purchase the no-fee class because we already charge a low flat fee (often below one per cent, given the size of our client portfolios) for our discretionary service.
The coupon payments are also taxed as income, so it can make sense to own them through your registered retirement savings plan or tax-free savings account.
That said, getting high-single-digit or low-double-digit coupons offer excellent returns even if they are taxed at higher levels than dividends and capital gains.
For the most part, notes will still fluctuate in value with the markets, so one must be comfortable with both this and with knowing it will take some time for the coupon payments to kick in. The notes purchased today will also be called away when markets ultimately recover, so the upside is capped.
Therefore, growth-oriented investors should still have an appropriate offsetting long position in equities.
Overall, we've taken our bond weightings down to our lowest allowable level and replaced them with notes while maintaining a reasonable equity allocation. This is also an excellent fit with our goals-based approach that targets specific returns for individual clients instead of trying to beat some market index.
Martin Pelletier, CFA, is a senior portfolio manager at Wellingtonaltus Private Counsel Inc, operating as Trivest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.