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What Now Brown Cow?

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We know that many are now questioning the longevity of the equity market run while the bond markets appear to be challenged in the face of rising rates.

 

We have all just gone through a ten-year bull market in both equities and bonds and It is possible that the easy money has been made. A tree doesn’t grow to the sky and we believe that within the next few quarters we may experience continued volatility in both equities and bonds.

 

Traditional wisdom has always suggested that in periods of challenging equities, one should flee to the safe haven of bonds. In our “new normal” world of rising bond yields this is not the case. Bonds appear to be in challenged territory. What does one do?

 

The simple answer is “get out of the way”.

 

In other words, both of our favourite and well-known asset classes (stocks and bonds) could now be challenged.  We don’t like seeing losses. What now Brown Cow?

 

Our thoughts are these

 

First the simple epithets. “you need to reduce risk, and you have to have downside protection” What this suggests is a reduction in both equities and bonds for a period, but not a complete exit from either. It would be unwise to be naked (= zero allocation) to any of the usual asset classes, only because as much as we all expect uncertainty in both bonds and equities, that uncertainty is not a certainty. At the same time, you need to mitigate risk outside of the usual markets.

 

Our practice as you know is to be proactive, and not reactive. To this end we have spent the last month reviewing alternatives. One that we have found is structured notes. These can provide good consistent returns while at the same time offering downside protection. Technically, they are considered fixed income but they are not bonds. They are notes which are backed by the credit of the issuer, which is most commonly either CIBC, Scotia or National Bank.

 

There are several different varieties of these notes and they all have different objectives. Some are looking for upside potential, others downside protection. We are looking for downside protection and a steady return. These operate on the same basic premises;

  1. They have a fixed coupon.
  2. They have a fixed term.
  3. There is an underlying security.
  4. Through the term, if certain criteria are met, you may get your money back early.
  5. At maturity, as long as the underlying security has not gone below a certain floor price. You get your money back.

Let’s look at an example. The CIBC Autocallable Coupon Notes linked to Canadian Banks Index ETF (ZEB). As per above.

 

  1. The coupon pays 6.70% semi-annually. It pays out as long as the ZEB is not down more than 30% of the initial price.
  2. It has a term of 7 years.
  3. The underlying security is the Canadian Bank ETF, ZEB. It just holds all 6 bank stocks.
  4. If the ZEB is up 10%, since inception, on any Semi-annual Autocall date. You get called away meaning you get your original investment back.
  5. At maturity, if over 7 years the six banks are down more than 30%, you receive the actual amount. We view this event as very unlikely. Otherwise, you recive your initial principal plus any coupons paid out.

Again, there is some potential that at the end of 7 years you may get less than your original investment but, in our view, this would be an unlikely outcome. With these notes the most likely event is that you get your money back plus coupons (get called) early.

 

Our objective as always is to be forward looking while we are still in what we consider to be a fairly positive environment. We anticipate moving some traditional assets, equities and fixed income into these structured alternatives. The time to look for alternatives, is when you have a clear mind and calm seas, not when there has been a market disruption and you are under duress.

 

These notes are not always available like a stock, bond or mutual fund, but they are issued regularly so you will have an opportunity. We understand that this concept will be new to most but we will be calling you to give you heads up before a new note comes up for offer. In the meantime, as always, if you have questions we are here.