Structured notes can offer investors protection in volatile markets

Martin Pelletier: Structured notes offer an excellent alternative to both stocks and bonds

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The big market swings of the last two weeks have been hard to stomach for both retail investors and seasoned professionals, but what makes them particularly challenging is that the type of trading that is taking place is mostly driven by central bank speculation.

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Take last Tuesday’s 4.3 percent correction in the S&P 500. According to Bloomberg, this was not only the biggest single-day drop since June 2020, but also the lowest average volume for a sell-off of this size since 2018. The cross-asset correlation from equities to bonds to commodities, as tracked by Barclays PLC, also showed values ​​that were among the highest since 1981.

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That means investors need to be patient and anticipate more of these big, small-volume moves, at least until there are signs the Federal Reserve will suspend rate hikes, indicated by factors like the core CPI reports.

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Having patience can be a difficult thing in such range bound, volatile markets. But there is one strategy we are employing that we think offers an excellent alternative to stocks and bonds moving together in this central bank-driven market.

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Structured notes are an equity/bond hybrid because they are a debt security issued by a bank that contains an embedded derivative component that results in a coupon payment linked to the performance of a specific index, exchange-traded fund, or even a basket of stocks.

There are many different note strategies, but they generally offer different levels of downside protection compared to simply owning the market. Upside participation is often limited to just the coupon payment received, but can be very attractive in this low interest rate and range environment with yields between 5% and 20%.

For example, we recently participated in a callable income note issued by Canadian banks. It will pay an annualized coupon of 9.54 percent monthly, subject to Canadian banks falling no more than 40 percent from current levels. Keep in mind that many are already down 15 to 25 percent from their April highs.

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If they fall more than 40 percent, you simply miss that month’s coupon payment, but it will be paid again the following month if the banks are above the negative 40 percent threshold.

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At the end of the seven-year term, assuming it’s not canceled beforehand (it has a 105 percent calling feature), you’ll get all your money back as long as the banks aren’t more than 40 percent down (which has never happened before) plus the conditional coupons on the way.

Overall, we currently hold between 30% and 50% of our client portfolios in debt securities, some of which have been created specifically for us by Canada’s banks’ capital markets groups. That way we can frame them around our outlook and include stock indices like the S&P/TSX Composite and the S&P 500, or even specific segments like agriculture, technology, materials, banks and energy.

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It’s important to note that banknotes can have sales commissions of 2.5 to 4 percent, but we always buy the no-fee class because we already charge a low flat fee (often under 1 percent, given the size of our banknotes). client portfolios) for our wealth management service.

The coupon payments are also taxed as income, so owning them through your registered retirement plan or tax-free savings account may make sense. However, coupons in the high single digits or low double digits offer excellent returns, even if they’re taxed more heavily than dividends and capital gains.

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For the most part, the value of the Notes will still fluctuate with the markets, so it’s something to be comfortable with and know that it will take some time for the coupon payments to eventually recover, so the upside potential is limited. Therefore, growth-oriented investors should still have a reasonable compensatory long position in equities.

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Overall, we have reduced our bond weightings to our lowest allowable level and replaced them with debt securities while maintaining a reasonable equity allocation. This also fits well with our goal-driven approach, which targets specific returns for individual clients rather than trying to beat a market index.

Martin Pelletier, CFA, is Senior Portfolio Manager at Wellington-Altus Private Counsel Inc, working as TriVest Wealth Counsel, a private and institutional investment firm specializing in discretionary risk-managed portfolios, investment review/oversight and advanced tax, estate and wealth Planning.


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