Thursday, September 21

Structured notes are growing so rapidly it’s fascinating to watch — here’s why

Martin Pelletier: If you are weary of bond market and equities, consider the almost 10% performance of these investments

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I will be speaking in Toronto this week at the SPiCanada 2023 conference on structured notes, a segment of the investment market that has been growing so rapidly that it’s been fascinating to watch.

The structured notes market is now worth more than $91 billion in Canada, but is expected to grow much bigger, especially if we see more years like last year when a whopping $32-billion worth of notes were issued, according to Tiago Fernandes, head of Data and Platform at WallStreetDocs Ltd. For perspective, Canada’s entire exchange-traded fund (ETF) market is worth approximately $365 billion.

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We think structured notes have grown in popularity for a couple of reasons.

Investors have grown weary of the bond market given the large losses they’ve experienced as central banks raised interest rates at their fastest-ever pace. They were told for the longest time that bonds were the safest part of their portfolio and yet they have been among the worst performing. This is because the longer the duration, or term of the bond, the greater the sensitivity to interest rates. Interest rates fell for the longest time, which rewarded those who had gone out the furthest in term, but the opposite has happened now.

For example, the FTSE Canada All Government Bond Index has a weighted average maturity of 10.4 years, which is considered a medium level of duration. It has lost an annualized 4.8 per cent over the past three years, been flat over the past five years and made a paltry annualized 1.7 per cent over the past decade.

This leaves investors looking at equity markets that have been extremely volatile over the past three years and highly concentrated among a few megacap stocks, which most Canadians don’t own a lot of. Not surprisingly, many have shifted to owning cash or high-interest savings accounts paying more than five per cent. Compare that to the 9.55 per cent effective performance on structured notes in Canada so far this year, according to data gathered by Fernandes.

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Among the adviser community and more traditional, transaction-based investment advisers, the 2.5-per-cent upfront, one-time sales commission option on Class A structured notes can also be too enticing to turn down compared to the no-fee, Class F notes that we and other discretionary managers use. We think this will eventually come to an end, though, as it gains attention from regulators who have been busy banning upfront commissions on mutual funds.

Overall, we prefer to look at structured notes as just another instrument in our toolbox to manage risk in our individual client portfolios and the balanced fund we manage. This has allowed us to reduce our bond weightings and replace them with what we consider to be conservative notes, including those with large downside protection that have barriers ranging from 30 to 100 per cent. We also like those notes that pay us monthly contingent coupons, and those with something called geared buffers, meaning they remove the binary nature of the downside barrier.

We think notes make a lot of sense within registered accounts to offset the impact of them being taxed as income. That said, don’t forget that in a traditional 60/40 balanced portfolio, 40 per cent would be taxed as income, so a note-replacement strategy has a net-zero tax impact, other than paying tax because you are making money.

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As with any new and rapid growing investment product, it is natural to expect some criticism. We particularly hear that from those who have constrained themselves to more traditional investment models that are already being heavily disrupted by alternative market segments such as private equity and derivative overlays, including covered-call and put writing.

That said, there is, no doubt, some complexity with notes, so it’s worth relying on the expertise of an investment manager that understands why they were created, how they’re managed and how they best fit within your portfolio from a risk-and-return point of view.

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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