Flat returns for the past two to three years for both stocks and bonds and the uncertainty of what lies ahead is causing a lot of angst for investors, many of whom may be enticed to go to cash and money markets that are paying as much as five per cent in interest.
There is one strategy, though, that we have found very effective for our goals-based approach within our client portfolios, including the risk-managed balanced fund we oversee. It has provided a significant return spread to passive benchmarks and has done so while delivering a lower standard deviation.
Having lower variability really helps provide comfort when markets correct and prevents emotion from entering the investment decision-making process, thereby improving the likelihood of reaching your goals and objectives.
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.
Some use them as an equity replacement, but we prefer to allocate a large portion of our fixed-income exposure, especially as they are taxed in the same manner. Owning them within registered vehicles such as registered retirement savings plans and tax-free savings accounts can therefore make a lot of sense.
The nice thing about structured notes is that there are many different strategies that can be deployed, and they can be built around a particular outlook, whether that’s a flat to down market or even a bullish scenario. They can also be diversified among broader equity indexes such as the S&P/TSX composite and S&P 500, or even particular segments of the market like agriculture, technology, materials, pipelines, banking and energy.
In our balanced strategy, we’ve taken our fixed income down to 10 per cent and added up to 35 per cent in notes while maintaining direct market exposure for the remaining 55 to 60 per cent. We really like this alternative approach to the traditional 60/40 portfolio, which could remain challenged for some time in this uncertain interest rate and inflationary environment.
Digging deeper into this allocation, we currently favour what are called contingent income notes, which are designed to pay a monthly coupon as long as the underlying index doesn’t fall below a particular downside barrier.
For example, we recently bought one on the Canadian banks that will pay a 13.3-per-cent annualized coupon each month as long as they don’t fall 20 per cent from current levels. If they do, we miss the monthly coupon for as long as the banks remain below 20 per cent, but the coupon will return once they rise above that threshold.
We’ve created a blend of these types of notes that when included in a fixed-income allocation would contribute an average yield of seven per cent with downside barriers averaging 40 per cent. For some perspective, the iShares Core Canadian Corporate Bond Index ETF currently has a 5.4-per-cent yield to maturity.
We would also add a smaller amount of upside torque via higher-yielding auto-callable structured notes within this fixed-income allocation, not unlike those who allocate a percentage to high-yield non-investment-grade bonds.
In this regard, one could assemble a portfolio of these notes with a 14-per-cent yield paid annually if the underlying index is zero per cent or higher on the annual call date. The nice thing is this portfolio would have embedded downside barriers averaging 35 per cent, meaning you get all your money back if their underlying indexes are above this barrier if the notes are not called away within the five-to-seven-year term.
Finally, one could also do a 100-per-cent principal protected note that would not have a monthly or yearly coupon, but rather track an index. For example, we recently priced out a note on seven large-cap Canadian companies that will pay out more than 3.3 times the level of their weighted performance over the next five years and the principal is 100-per-cent protected.
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As you can see, adding some alternative exposure, such as structured notes, to your portfolio can be a great way to remove some of the anxiety of what lies ahead and keep you invested and focused on achieving your long-term goals.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus 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.
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