How Structured Notes Might Fit into Your Retirement Portfolio – Pt. 2

In part one, we gave you the basic background information about what structured notes (SN) are, how they are designed, what they are used for, and the risks associated with them. In part two, we will try and give you a more practical look into SNs and how they might fit into a portfolio.

Every financial adviser or firm has their own way of portfolio design and description. Two of the more common approaches are the “bucket approach” and the “core-satellite design.” The important point here is that SNs are an enhancement to the portfolio design and not a “core” or “bucket” investment. As a rule of thumb, for most investors, 5-15% of their entire portfolio is a reasonable amount to allocate to SNs. To further reduce risk and further diversify, the investor should ladder their SN holdings much like one would ladder bonds or CDs.

As of the writing of this article (September 2021) retirees throughout the country are struggling to find ways to create income in their portfolios to use as passive income or as a counterbalance to their more aggressive equity holdings. For example, the US 10 Year Treasury Bond average yield is 1.33% and the 20-year yield is 1.919%. According to the website www.FMSbonds.com , the average 20-year AAA Municipal Bond rate is 1.30% and 1.5% for 30 Year yields. The website www.GMSgroup.com states that the average 20+ year yield for AAA Corporate Bonds is 2.964%. Lastly, according to a Janus Funds study dated March 2021, the average dividend yield for the S&P 500 is 1.44%, a 100-year low.

With core inflation rates hitting highs not seen since the 1970s now you can see why anyone looking for income (especially retirees living off of their portfolio earnings) is having such a difficult time using the more traditional methods while limiting their risk of loss, market volatility and direct correlation to the equity markets. A word of caution is necessary here because an opportunity for 6%, 8%, 10% yields from SNs can be very tantalizing. The investor (and adviser) must be aware of the risks associated with SNs as we described in part one and proceed cautiously.

Every investor’s goal and objective are different and the approach to portfolio design should reflect those individual goals and objectives. With that said there are three basic types of SNs:

1. Partial Principal Protected Notes
2. Income Notes, and
3. Growth Notes.

Each of these has a different product design, risks, market outlooks (bull, bear or neutral) and market conditions (interest rate factors, volatility and correlation to name a few). Let’s try and break down the 3 types of SNs for you and how they might fit –

1. Partial Principal Protected Notes – As the name indicates, these are the more conservative design with the goal of gaining exposure in an average to high-risk asset such as a stock index(ices) or individual issue of stock(s), with limited downside risk to your investment. In order to have downside protection, SN will also limit its upside gain by using “capping” the return through either a hard cap value or participation rate value. For an investor who may be lacking confidence in the upward trajectory of an index or stock, the PPN may be a valuable tool that will allow an investor to capture some or all of the possible upside of the underlying investment while protecting some or all of the original investment from a negative return. You will find a range of terms, usually between 1-5 years, as well as a range of returns which will be partly dependent on the market volatility and interest rate environment at the time of issue.
2. Income Notes – The goal of the Income Note is, as its name indicates, to create a periodical income stream (monthly, quarterly) of higher relative to traditional bond yields. To provide this higher yield, the investor will have contingent downside protection of their investment, typically 20-40%. Once this level is “triggered” the principal is no longer protected and will fluctuate in value, up and down, in lockstep with the underlying asset i.e., an index like the S&P 500 or individual issues like an ETF or individual issue of stock. Depending on the conditions of the Income Note, the regularly scheduled interest will be paid unless it is directly linked to the trigger mechanism of the underlying asset. At maturity, the investor will receive a return of principal either in full or partially depending on whether or not the trigger level is breached. As with the PPN’s the terms of the Income Notes typically range from 1-5 years. An Income Note is not a substitute for a bond but it can provide diversification benefits to a bond allocation. It generates income without assuming interest rate risk but may be more susceptible to market volatility.
3. Growth Notes – This issue is for the investor who may be bullish about the market, an index(ices) or individual issue(s) but wants to have some level of downside protection. The upside maximum return may be capped or uncapped usually depending on the term of the note and sometimes includes leveraged participation. In turn, the investor may have a “buffer” of protection meaning to a limited point, the principal is protected. The buffer amount is typically between 10-30% on the downside which helps protect against an initial decline in the underlying asset’s value. After the buffer is breached, the downside is typically a 1% loss in principal for every 1% loss of asset value. Conversely, if the buffer is breached but the asset then begins a recovery, the recovery rate is also typically 1% gain for every 1% recovery of the asset to its original starting value.

Hopefully, with a better understanding of the kind of SNs available, let’s talk about how they might fit into a portfolio. As we stated at the beginning of the article, the SN should be a limited part of the overall portfolio design; an enhancer or what we call a satellite investment. Our recommended range is 5-15% of the overall portfolio value.

The starting point would be asking three questions:

• First, what is my market outlook – bullish, bearish or neutral?
• Next, what are the market conditions – level of interest rates, level of volatility and the degree of correlation?
• Lastly, which of the type(s) of SN best fits my objective(s) – principal protection, income or growth?

Now we have to look at the term of the SN, or how long your investment will be “tied up”. Remember that these are investments with a specific time frame and limited liquidity. The notes can be sold mid-term, but the terms of the note are no longer guaranteed and may have to be sold at a discount or loss. With that said, most terms are between 1-5 years. Evaluate your need for liquidity, your market outlook, need for income (or not), etc. then decide how much to invest in the SN.

SNs may not be a replacement for bonds, however, like your bond portfolio, you should consider laddering your investments into SNs. For example, what one might do is divide their total SN investment allotment by 12 and purchase 12 individual SNs that mature in different months. In other words, you have 12 different SNs with a maturity date on the 15th of every month January-December. By taking an approach like this, you can help level out some of the market volatility, similar to dollar-cost averaging into other types of investments and investment plans. You can extend this out by years as well. SNs may, like bonds, have a call feature that will allow the underwriting institution to dissolve the offering early if certain levels are reached. This usually occurs when the underlying asset trades above the initial value shown in the original offering. At that point, the investor will be paid out in whole and any interest payment will cease as well. Then the consideration will be to roll over that principal into a new SN using all the same guidelines already mentioned. Over time an investor may find SNs with similar maturity times. This is why a consistent review of your portfolio is so vital and may need a rebalancing from time to time.

As we always advise, please speak to your tax, investment and legal advisers before investing in structured notes (or any investment for that matter). This is not an investment for everyone but it is one that we have found to be an incredible value add or enhancer to our client’s portfolios when designed and used appropriately.

Because structured notes are a security, compliance wants you to make certain you understand the following:

A purchaser should evaluate and understand all of the risks and costs of an investment in Structured Notes (SNs) prior to making any investment decision. A purchase of an SN entails other risks not associated with an investment in conventional bank deposits. A purchaser may not have a right to withdraw his/her investment prior to maturity or could incur substantial penalties for an early withdrawal, if permitted. A purchaser should carefully read the disclosure statement and any other disclosure documents for an SN before investing. An investment in SNs is not FDIC insured and is subject to credit risk. The actual or perceived creditworthiness of the note issuer may affect the market value of SNs. SNs will not be listed on any securities exchange. Even if there is a secondary market, it may not provide enough liquidity to allow purchasers to trade or sell SNs. As a holder of SNs, purchasers will not have voting rights or rights to receive cash dividends or other distributions or other rights in the underlying assets or components of the underlying assets. Certain built-in costs are likely to adversely affect the value of SNs prior to maturity. The price, if any, at which the notes can be purchased in secondary market transactions, if at all, will likely be lower than the original issue price and any sale prior to the maturity date could result in a substantial loss. SNs are not designed to be short-term trading instruments. Purchasers should be willing to hold any notes to maturity. The tax consequences of SNs may be uncertain. Purchasers should consult their tax adviser regarding the U.S. federal income tax consequences of an investment in SNs. If an SN is callable at the option of the issuer and the SN is called, the holder will receive only the applicable redemption amount and will not receive any coupon payments that would have been payable for the remainder of the term of the SN. SNs are Not FDIC Insured, May Lose Principal Value and are Not Bank Guaranteed.