Kevin Michels, CFP®, EA
With inflation continuing to tick higher, expected interest rate hikes, and low bond yields, we’ve been in search of an alternative investment that will provide better returns than bonds without the full risk of stocks.
To be clear, we’re not abandoning bonds altogether. They have their place in a portfolio, even when expectations on returns aren’t ideal. They provide a great diversifier in years when we see a falling stock market. Since 1970, the stock market has had nine calendar years with a negative return. In each of those nine years, the bond market provided a positive return. We will continue to invest in bonds as a ballast for the portfolio when stocks are in a downturn.
However, given the current environment we’re in, and low expectations for bond returns in the future, we’ve been looking to replace a portion of our bond allocation with something that will keep better pace with inflation.
We believe “structured income notes”, is one solution to the low yield, high inflation problem. This is a new asset class in our portfolios, and we thought it would be a good idea to provide some initial education.
An income note is simply an obligation from a bank to pay a certain amount of income if certain contingencies are met. For example, in our case, we are purchasing a 3 year note from Bank of Montreal. The note guarantees to make a 0.975% interest payment on the 16th of each month as long as the S&P 500 Index, Russell 2000 Index, and NASDAQ Index are all within 75% of their initial value the day we bought the note. In other words, as long as none of the indices are down more than 25% on the 16th of each month, we receive our interest payment. After 3 years, as long as all those indices are within 60% of their initial value, we get our full principal back. In other words, at maturity, as long as none of the indices are down more than 40%, we receive our full principal back.
That works out to be an 11.7% annual return. In comparison, new highly rated 3-year corporate bonds are paying around 2% - 3% annually and the 2-year treasury rate is 1.50%. Keep in mind, you don’t get this extra expected return without taking on additional risk and as is the case with every investment, there are risks we have carefully considered.
As mentioned before, we only get our coupon on the 16th if all three indices are within 75% of their value on the day we purchased the note. If one of those indices drops below 75% of its initial value, we won’t receive our interest payment for the month. Given the historically low rates bonds are currently paying, even just three months’ worth of interest payments at 0.975% monthly, would put us ahead of what most bonds pay in a year.
As mentioned before, we only get 100% of our principal back at maturity if all three indices are within 60% of their initial value. If one or more of the indices are below the 60% value at maturity, we participate fully in the loss. For example, if at maturity, the Russell 2000 was 55% of its original value when we bought the note, we’d only get 55% of our principal back. This is a real risk, and one we’ve studied intently. Our research shows that over a 3-year period, 94% of the time, all three of the indices are within 60% of their initial value. If we have the unfortunate timing of having a note mature when an index has dropped below the barrier, we’ll simply take the principal we receive and reinvest back into the lowest performing index. Continuing with the prior case, if we only receive back 55% of our principal because the Russell 2000 is down 45%, we’ll take our principal and reinvest it directly in the Russell 2000 and wait for the rebound. Also, keep in mind, the interest we receive throughout the life of the note offsets the reduction in principle. For example, over the three-year period, if we received 24 months of interest, we received a total of 23.4%.
Statement risk refers to the price fluctuation of the income note. Just like other publicly traded investments, the price fluctuates daily and tells us what we could sell the investment for at that moment. Since we plan on holding the note until maturity, we don’t need to worry about the price if it’s within the barrier of 40%. For example, the indices could be down 30% and the price on your note may be down 20%-30% as well. However, as long as the indices are within the 40% barrier, you’ll receive your full principal back. We call this statement risk, because you may look at your statement one day and see the price of the note has dropped in value, but as long as we keep the note to maturity and the indices stay within their barrier, you receive your full principal back.
Credit risk is the possibility of a loss resulting from the bank’s inability to meet its debt obligations. In other words, if the bank goes bankrupt, they may not pay back the full value of principal, regardless of if contingencies are met or not. We’ve mitigated this risk by only considering notes from banks who have prime and high-grade credit ratings. For example, in this case, BMO bank currently has a credit rating of AA-, which is high-grade.
The bank issuing this note, BMO, has the right to call the note at any point after the first three months. That means, they will end the contract and return your full principle. Typically, they’ll call the note if the value of all three indices are higher than their initial value. If it looks like the note is going to get called, we’ll either start shopping for another income note to roll the proceeds into, or we’ll reinvest the proceeds into an ETF.
The fees for an income note vary from note to note. They are built into the interest rate we receive, so you don’t see a debit or line item on your statement. Our contact at First Trust Portfolios shops the specifications on our desired note across multiple banks to see who will give us the best pricing. The fees are typically around 1.5%, which is much higher than the fees we pay on our low-cost ETFs (between 0.03% - 0.40%). We’re always super conscious of fees, but don’t mind paying a higher fee for an investment we believe is going to outperform a lower-cost investment.
We view structured income notes as our hedge against inflation and rising interest rates for the bond allocation of our portfolios. Yes, the risk of principle is greater with structured income notes than bonds, but they don’t come with the same interest-rate risk that is so prevalent with bonds today. Bottom line, we continue to believe in our philosophy of diversified portfolios and this new asset class helps us diversify away from some of the risks bonds currently face.