Structured securities can provide protection for investors in volatile markets

Martin Pelletier: Structured banknotes provide an excellent alternative to both stocks and bonds

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The significant market volatility over the past two weeks has been hard to endure for retail investors and seasoned professionals alike, but what makes it particularly challenging is that the type of trading that occurs is primarily driven by central bank speculation.

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Take last Tuesday’s 4.3 percent correction in the S&P 500. It was not only the largest one-day drop since June 2020, but the lowest average sell-off of its size since 2018, according to Bloomberg. The cross-correlation of assets from stocks to bonds and commodities according to Barclays Plc tracker also showed readings ranked highest since 1981.

This means that investors will have to be patient and anticipate more of these big moves of lower volume, at least until there are signs that the US Federal Reserve will halt its interest rate increases, factors such as core CPI suggest. reports.

Being patient can be difficult in these types of choppy, range-bound markets. But there is one strategy we have published that we believe provides an excellent alternative for both stocks and bonds moving together in this central bank driven market.

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Structured paper is a hybrid stock/bond because it is a debt obligation issued by a bank that has 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 feedback strategies, but they usually offer varying amounts of downside protection compared to directly owning the market. The upside share is often limited to only the coupon payments received, but it can be very attractive in this low-priced, range-bound environment, with returns of 5-20 percent.

For example, we recently shared a recallable income note in Canadian banks. You will pay an annual coupon of 9.54 percent on a monthly basis provided that Canadian banks do not fall 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 it drops more than 40 percent, you simply miss the coupon payment that month, but it will be paid again the following month if the banks are above the negative 40 percent threshold.

At the end of the seven-year period, assuming you don’t call it in advance (it has a 105 percent call advantage), you’ll get all of your money back as long as the banks haven’t dropped more than 40 percent (which it hasn’t before) plus unit coupons along the way.

In general, we currently operate 30 to 50 percent of our clients’ portfolios in the form of notes, some of which are tailored to us by capital market groups in Canadian banks. This way, we can tailor it to our forecasts and include stock indices like the S&P/TSX Composite and S&P 500 or even specific sectors like agriculture, technology, materials, banking, and energy.

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It’s important to know that notes can have sales commissions of 2.5 to 4 percent fixed, but we always buy a no-fee category because we actually charge a low flat fee (often less than 1 percent, given the size of our client wallets) for our discretionary services.

Coupon payments are also taxed as income, so it makes sense to own them through a registered retirement savings plan or tax-free savings account. However, having low single digit or double digit coupons provides excellent returns even if they are taxed with higher levels of dividends and capital gains.

For the most part, banknotes will still fluctuate in value with the markets, so one should be comfortable with both of this and knowing that it will take some time for the coupon payments to start. Notes bought today will also be called when markets finally recover, so upside is limited. Therefore, growth oriented investors should still have a suitable long equivalent position in stocks.

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Overall, we reduced our bond weights to the lowest allowable level and replaced them with notes while maintaining a reasonable capital allocation. This is also an excellent fit for our goal-based approach which targets specific returns for individual clients rather than trying to beat certain market benchmarks.

Martin Pelletier, CFA, is a Senior Portfolio Manager at Wellington-Altus Private Counsell Inc, serving as an advisor to TriVest Wealth, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment review/monitoring, advanced taxation, real estate and wealth planning.


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