I have been getting a lot of questions about where to invest in the current market and what are the options for those that don’t want to get into equities right now nor do they see bonds of any use.
I wanted to go over what I am doing as an alternative (not steering away from my long-term perspective in my portfolio but more as a hedge).
A disclaimer that this may not be right for you as it does have risks (detailed below) and it should not take you away from your original portfolio objective as a long-term investor should not be worried too much about the recent market turbulence. This is for those looking for more of an alternative and has the ability and risk tolerance to do so. I will go over the risks in more detail below.
Secondary market notes what are they?
They are quite complex and I can go over the logistics verbally over the phone if needed in more detail but I will aim to go over the basics here.
As most markets and indexes are presently down it does pose an opportunity to buy at value with some protection as the notes offer an element of protection on the downside risk.
How do they work?
Structured Notes have a barrier of paying 100% back at redemption if certain levels of the underlying indexes are met.
This is normally over 65% but can be as low as 50% of the strike value of the underlying indexes linked depending on the specific note, as like stocks and funds they are all unique.
The coupon is based on the underlying indexes and normally pays on the strike level on the date that issued. I.E, if over 80% of the strike level at the observation date you will get the coupon (if 8% a year) it would pay 2% a quarter at the observation date.
An example:
You buy a Note with the underlying indexes of FTSE100 and S&P500 with 65% protection and 80% coupon level of 8% observed bi-annually with memory feature on a 5-year term with a strike on Jan 1st 2019. Buying on the secondary market value is 80% less on Jun 1st 2022.
The FTSE100 and the S&P500 issued at 1000 (hypothetically) on Jan 1st 2019 and are now 20% less so can buy the note on the secondary market at 20% less value.
You buy the note for 20% less on June 1st 2022 it has the same coupon features and maturity date. In reality, it means you are able to buy a note than what it was originally priced at and the maturity date is less or closer to the end. The time a note may not pay out is if the links or underlying investments drop by certain points.
If this doesn’t make sense, please speak to me for clarification before investing.
Some Scenarios
The next observation date (if done bi-annually) would be January 1st 2023 if the underlying indexes are above 80% of the strike value when issued (1000) you will get the coupon of 4%.
If the underlying indexes are below you will not get the coupon. But, the coupons that have been missed and not been issued will be accrued for the next time if above 80% level at the next observation date (Jan 1st or Jun 1st each year) as it has a memory feature.
E.G – The next observation (on the example above) is at 750 on Jun 1st 2023 (one underlying index is 75% less than 80% of the original strike value of 1000) you will not get your coupon. However, at the next observation date, the underlying indexes are above the 80% level you will get 8% (4% for the present coupon and 4% for the one missed).
At maturity, if the underlying indexes of the example (FTSE 100 and the S&P500) are above 65% of the original value you will get 100% back.
(Even though you bought on the secondary market being 20% more than you paid).
Although, if the index that is linked is below the 65% barrier level from the issue date you will get a dollar for dollar amount of the lowest index level. If the lowest index was 600 you would get that amount back ($10,000 invested would be $6000). But, as you invested on the secondary market 80% less you will lose 20% minus the coupons that you have collected during the time in the note.
Here is a Fact sheet to explain the logistics on the primary market that might make it visually easier to understand rather than my explanation
The risks of Secondary Market Notes are:
- Illiquid and if you look to sell early you might get less than what you put in.
- Default risk of the issuer (normally a large bank like Morgan Stanley)
- These are not for people looking for a fixed return
- You don’t get full upside growth
- Loss of capital
- They are complex and note for investors that don’t understand the risks and logistics
Who are they for?
- Someone who can afford to have capital locked up for the medium term
- Someone looking for some diversity to equities and wants a higher return than bonds
- Someone willing to have an element of risk in their portfolio and understands the risks and can put capital at risk
What are the potential benefits?
Most notes offer some protection if the market falls and offers coupon payments. So, in a stagnant or slightly down market, you could be in for potentially positive gains.
Why the secondary market?
Presently, right now a lot of the indexes or stocks are down from last year so buying notes for 20% less than what they were for example a year ago with the ability potently to get 100% back at maturity. (again see the note specificity this is not garmented)
What do the notes invest in?
Like funds, they can invest in a range of indexes and stocks. Normally, some of the safer ones invest in large indexes such as the S&P500 rather than individual stocks.
What range of secondary market notes are on offer?
Again, like funds they have 1000s so can look for a range of options on the secondary market. Some with 6 months to maturity linked to indexes and others with 5 years based on individual stocks.
I have attached a small sample showing some that are on offer on the secondary market but they have 1000s in different stocks indexes and maturities.
What are my thoughts?
Investors are stuck in a hard position right now due to equities being volatile and bonds not yielding enough in real terms.
Long term, investors should be able to ride out the storm and should not change portfolios based on short-term events. However, for those looking for something different or to diversify in the current market that is currently not looking too bullish these may be an option as are presently selling at low values and have some slight protection (not guaranteed).
As with any investment ensure that you fully understand the risks involved and I am happy to go over them in more detail for any that do want to look further or looking for specifics objectives and notes.
If you do have any questions, please feel free to ask but thought this might be an option for the alternative part of the portfolio as personally, I am buying these right now as they look attractive.
Anyone that is looking at this as an alternative please reach out by email at info@investmentsforexpats.com as these are only for sophisticated investors so want to ensure you have the ability and knowledge to take the risk.
