With Interest rates turning downward yet again, uncertain economic growth and recent market increases that lend to speculation of an anticipated downturn this is a challenging period for investors. This is especially true in the fixed income side of the aisle which would tend to be a recipient of any market trimming. Interest rates have been declining for more than 30 years, creating a tailwind in the bond markets.
Investors are constantly questioning where to find safety in the markets, beyond just staying in cash. Traditionally bonds have been the answer, providing the necessary ballasts to navigate volatile markets. While they continue to provide traditionally low correlation to the broader markets and therefore lower an overall risk profile it is important to examine the upside potential vs downside risk in any investment. While bonds may produce positive returns should interest rates remain low, they will likely face significant headwinds when interest rates begin to rise again.
As such, many investors have elected to underweight these bonds in their allocations, leaving the option of holding cash or looking for bond alternatives with better upside and accepting that this may expose them to more volatility for the time being. Many have elected the latter and are constantly looking for alternatives that can produce positive returns and dampen volatility where possible. One such vehicle can be the Structured Note.
A structured note is a debt obligation that also contains an embedded derivative component that adjust the security’s risk/return profile. The return performance of a structured note will track both that of the underlying debt obligation and the index of the derivative embedded within it.
Buffered Notes are short-term structured note investments offering an enhanced return based on the performance of the underlying asset, coupled with a contingent amount of downside protection. For example, a well-designed Buffered Note may protect the investor for the first 10% of erosion of the underlying asset, but any decline in value beyond that is not protected. For example, if the Note has a 10% buffer and the underlying investments are down 12% over the term, the investor would see a 2% loss – protected 100% of the first 10% downside but full participation beyond the buffer.
A buffered note also typically offers increased upside potential as determined by the closing prices of the associated index. The participation rate for a buffered note is typically between 150%-300% on the upside. Occasionally, but not always, the upside potential may be capped (20%, for example).
Like any investment, risk exists. The pricing of these notes also vary significantly over time and are usually dependent on the volatility of the underlying investments used in the Note.
As with any investment, suitability and appropriate diversification is critical. While not for everyone, Structured Notes, especially in the current environment, can be a powerful tool as part of a well designed Wealth Management strategy.
R. Zeb Lowe, CFP®
M. Brandon Riley, CFP®
CERTIFIED FINANCIAL PLANNER Practitioners
COIGN CAPITAL ADVISORS LLC
Zeb and Brandon are two of the several partners at Coign Capital Advisors LLC in Salt Lake City, UT. As CFPs, they work as fee-only advisors to high net worth individuals and families across the country in a personal CFO role. They help their clients prepare for and respond to critical financial events as part of a comprehensive Wealth Management approach.