What’s Ahead:
- Many investors are familiar with the concept of fixed-income laddering – investing in bonds with different maturity dates.
- The same practice can be applied to Structured Notes to help reduce a range of risks, including reinvestment risk, interest-rate risk, and issuer risk.
- Rather than owning a buffered ETF, a diversified allocation of Structured Notes has the potential to better manage risk and help clients reach their financial goals sooner.
Investors continue to seek protective investment strategies, even as the U.S. stock market has rallied significantly since the start of 2023. The bear market of 2022 gave us a reminder that volatility can endure for several quarters – it’s not always a sudden spike in fear and immediate market free fall that can disrupt a financial plan. As time has progressed, though, and after two market cycles in the last handful of years, new risks and opportunities have emerged for financial advisors.
Structured Notes offer customizable features and the potential for tailored returns, which make for a compelling protective investment solution for risk-sensitive investors. To better harness their benefits, a laddering strategy – staggering Notes by maturity date – can aid in overall performance and risk management.
Advisors and even many retirees are probably familiar with the concept of laddering when it comes to traditional fixed-income investments. As a quick refresher, bond laddering is simply owning a basket of bonds, each with a different maturity date. As one bond matures, a new bond is purchased with an extended maturity. The aim is to reduce interest-rate risk and cushion the blow if market yields drop.
For Structured Notes, laddering offers a range of potential upsides. Let’s detail what those are and how they can help client portfolios. We’ll then touch on one growing trend in today’s marketplace that has us concerned for investors.
Time Diversification
Structured Notes are sensitive to market conditions when they are purchased. By spreading Notes out across a spectrum of maturities, investors can lower the risk of buying in at one inopportune time. Laddering, in effect, exposes the investor to a range of market scenarios – that’s a good thing as it pertains to tightening up the distribution of possible returns.
Along with broad market risks, the laddering method of purchasing Structured Notes may help reduce reinvestment risk with respect to volatile interest rates. For instance, we’ve seen the U.S. 10-year Treasury note yield range from under 2% to nearly 5% in the last four years. Layering in Notes one by one with varying maturity dates can stymie the chance of facing reinvestment when rates are low.
Liquidity
Many Structured Note investors have a known time horizon. They may need to draw on their portfolio’s income for daily expenses in retirement. The question often arises: “Why should I lock up my capital for 24 or 36 months in a Structured Note if I might need the cash soon?” It’s a valid concern, and here’s why laddering might be just the solution.
Laddering provides periodic cash flow as Notes mature at different times. If the client wishes to take the cash, that’s just fine. They can also use maturing Notes to reinvest in new Notes based on market conditions or new investment goals.
Liquidity is also helpful when plans change. A financial road map is never a straight line – there are often pit stops, detours, and even the occasional “I’m turning this car around!” In such instances, having Notes mature over regular intervals empowers the client and advisor to reassess market conditions and what other types of Notes (or even other investments) might better align with their refreshed plan.
Smoothing Out Returns
Dollar cost averaging is one of the more boring investment tactics, but it can be effective. Laddering is a related concept – by diversifying entry and exit points, investors can average out returns, mitigating timing risk and softening the blow if Notes were all purchased during one period of adverse market conditions.
The downside, of course, is that the client is less likely to hit a home run. If you picture the distribution of potential portfolio returns, laddering can squeeze together the performance curve without necessarily having a negative impact on the overall expected return.
Managing Credit Risk
There’s also the viewpoint that returns are smoothed further should troubles arise with a particular issuer. Most of the focus when it comes to risk management with Structured Notes concerns the fundamental health of the issuer. It makes logical sense that it’s not the best strategy to own Notes created by a single financial institution. Indeed, laddering augments tried-and-true diversification strategies to help increase the confidence interval of returns.
If a single issuer faces financial troubles, then perhaps just one of a client’s Notes is potentially impacted while the bulk of the allocation to Notes is unaffected. What’s more, the reality is that it’s usually not an all-or-nothing situation when it comes to corporate financial challenges. If an issuer’s credit rating changes just by one notch, holding a basket of Notes with staggered maturities means that not all Notes would be impacted simultaneously.
A Unique Portfolio
We’ve focused on some of the bad things we are trying to avoid. Now let’s focus on the positives. The portfolio laddering construction and management process is ideal in that the advisor can tailor Notes to their client’s specific goals. For a little Notes 101, each Structured Note is crafted with four simple parameters: Maturity Date, Return/Payoff Profile, Protection Amount, and the Underlying Asset.
Dollar cost averaging on the buy side and laddering maturities on the sell side empower the advisor and client to pull different levers at different times depending on ebbs and flows in risk tolerance and return objectives. If it’s agreed that a more aggressive allocation is warranted, then opting for Growth Notes with extended durations could be the right move. If the client requires more immediate cash flows, then Income Notes with a shorter duration might be optimal. As the market for Structured Notes develops, new underlying asset types could appeal to various investor types, too.
Bigger picture, laddering is simply more adaptable to changes. Today’s investors cannot afford to have a static allocation and hope that market conditions move in their favor. Staggered maturities and recurring cash flows can give the advisor and client more control and flexibility.
An Emerging Problem
A laddering strategy for Structured Notes is straightforward given the potential risk-management benefits. Something we see in today’s growing marketplace of defined-outcome ETFs is that investors commonly select one or just a few funds to own. By definition, buffered funds show the market when their holdings will mature. While not exactly like revealing your hand at the blackjack table, there is the chance that if too many investors hold the same ETF, the market could work against all of them at once.
Buffered ETFs commonly have maturities just once per quarter, too. Along with the funds charging high fees, there isn’t a whole lot of choice if an investor aims to reduce maturity risk. We assert that the better alternative is to own Structured Notes directly. Not only can the buyer build an allocation based on their preferences, but the Note portfolio might also beat the off-the-shelf buffered fund on costs.
Owning Notes through a separately managed account (SMA) is another solution if advisors don’t have the time to take the DIY approach. Halo partners with several asset managers who own the portfolio management process so advisors can focus on direct client activities.
The Bottom Line
The laddering approach with Structured Notes has the potential to reduce a variety of risks while smoothing out overall returns. There’s no sure thing in markets, but there are smart strategies that can better position client portfolios for success without added costs. Staggering Note maturities may optimize return outcomes for retail clients, and it just might be more effective than going the ETF route.
Content and any tools discussed are provided for educational and information purposes only. Halo Investing makes no investment recommendations and does not provide financial, tax, or legal advice. Any structured product or financial security discussed are for illustrative purposes only and are not intended to portray a recommendation to buy or sell a particular product or service. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples are provided for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results.
Structured notes have complex features and may not be suitable for all investors. They are sold only by prospectus and investors should read the prospectus and pricing supplement carefully before investing as they contain a detailed explanation of the risks, tax treatment, and other relevant information about the investment. The tax treatment of structured notes varies depending on the offering, and can be uncertain in some cases. Structured products are sold through financial professionals, and investors should consult their accounting, legal, and/or tax professional before investing.
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