Larry Berman: Are structured notes a good fit for your portfolio?

This week’s educational segment is inspired by a viewer email. Peter from Sydney, B.C. writes:

Regarding structured notes: Where are they best positioned in a retirement portfolio where one does not need it as regular income (TFSA, RIFF)? What would you recommend as a maximum weight?

Peter,

A structured note is often an expensive strategy designed to attract risk-averse investors. Typically, the provider and the seller are making five to 10 per cent in fees over the life of the note. They are all very similar in the structure and they can be tax-efficient generating capital gains. Without getting very specific in terms of providers, what I will suggest today is possibly creating you own structured outcome!

Principal protection is often a selling feature (you need normal interest rates for this, typically). I mean, who does not want to lose money when making an investment. Now that interest rates are high relative to the past decade of ZIRP, these PPNs are coming back. In their simplest form, you are buying a guaranteed return if a certain outcome happens. The issuer is often a counter party to the transaction (they are guaranteeing an outcome). One way to do achieve this is to buy a zero per cent coupon note or bond (known as a strip).

Today, one can buy a May 2030 U.S. Treasury for about US$77. It will mature at $100 on May 15, 2030, and hence the guaranteed return of your investment. What they leave out in the marketing typically is opportunity cost. The $23 can now be used to structure an outcome, typically with options. For simplicity, let’s say you invested a notional $520,000 – it will become apparent why I picked this odd amount below. At $77 for the note, you would pay about $400,000, which would leave $120,000 to spend on option structures.

For the S&P 500, one can buy Dec 2029 (at the money) 5200 call for about $1,400, and sell a Dec 29 (out of the money) 6000 call for about $1000 to cost a net of $400. Now you can buy three 5200-6000 call spreads for $120,000. Each call on the S&P 500 cost $400 with a 100 multiplier equals $40,000. I’m excluding commissions, but they are rather nominal.

Your maximum profit is 800 (S&P 500 index points) x three options, if by Dec 2029 the S&P 500 is above 6000 (which seems very likely, as it’s only a two per cent annual return). Based on a starting value of 5200 (5200 x 100 multiplier is where the $520,000 comes from), a 2400 point profit is about 46 per cent over 5.5 years or about eight per cent per year taxed as capital gains. You also have zero risk of capital loss because it’s a long call position.

The opportunity cost comparison would be to just earn the return in buying the bond at $77 for the same $520,000, which would allow you to buy a notional $675,000 or about 30 per cent return over six years or about five per cent annual return guaranteed as a capital gain.

To answer your questions Peter, they are tax-efficient, so taxable accounts make the most sense. If they are in retirement accounts, the ultimate return will be less tax efficient as income when withdrawn from the RRIF, but not the TFSA. As for how much they should be, it really depends on what you’re invested in and what the expected outcome might be. I do not have a favourite because at www.qwealth.com , we can create our own structures, so we do not use the more expensive notes that are available. So I, of course, prefer these custom outcomes. With all investing, diversify your style of investing for a better overall return. I like the S&P 500 because it will always hold most of the best companies in the world. There are other benefits to the structures – typically, one can buy them with a $5,000 minimum. You would need to have pretty significant savings to create these outcomes yourself. If you do, it’s probably worth the effort.

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