We could be in another financial bubble, but nobody really knows when a correction will take place. You might not even care if your investments decline by 20% or more over a year time frame if you are looking to invest over the next several decades. But alas, none of us will live forever, and nobody really likes to experience downside volatility. Sooner or later, we’ll have to deploy our capital for life, leisure, and charity. Not everybody wants to leave a financial legacy to raise spoiled kids!
One of the strategies I’ve taken to protect against downside risk is to buy various structured notes based on different indices like the S&P 500, Euro Stoxx 50, and the Russell 2000, or buy single stock structured notes of specific companies. Not only do I regularly rebalance my portfolios, I also consistently dollar cost average every month. You’ll be surprised how big a fortune you can create after just 10 years by methodically applying these two financial practices.
Structured notes are derivative products that usually provide hedged returns. In this post, I’d like to explain to you another recent structured note I bought to help illustrate how structured notes work. I buy all my structured notes through a Citi Wealth Management account. My other investment portfolios include: a Rollover IRA, a SEP IRA, a Self-Employed 401k, and a digital wealth advisor portfolio.
Below is the term sheet for a American Airlines structured note created by Citigroup. The offering says the buyer of such note will receive a 8.5%-9.5% annualized coupon paid quarterly over the one year duration of the non-callable note. The coupon will be paid so long as American Airlines is down no less than 25% from the date the note is offered.
The reason why I find this note attractive is because the final coupon payment is 9%. My target return for my Citi after-tax investment portfolio is 2-4X the risk free rate (4-8% a year) with relatively low risk given the portfolio size is relatively large. 9% is above my target return, and I’m relatively bullish on airlines given the decline in oil, and the strengthening dollar which should boost demand for US travel overseas, although it will hurt foreign travelers to the US. I’m also long Hawaiian Airlines as well.
Study the terms below.
Here’s a scenario analysis chart that is contained in the American Airlines term sheet to review. So long as American Airlines is at least 75% or higher than the initial sample share price of $48, the structured note owner will receive a 8.5% coupon. If American Airlines is down more than 25% from the initial share price, then the investor will still get paid the 8.5% coupon on his investment amount, but he will also lose the actual percentage amount once the 25% downside barrier is breached e.g. AA down 50% means you’ll lose $500 of your $1,000 investment, but still get $85 in coupon payments.
On the flip side, no matter how great American Airlines performs in one year, you’re capped at a 8.5% return. This scenario is terrible if American Airlines surges by 40% as some investment houses predict. My current macro thinking is that we’re in the second half of a bull market, and we’ll be lucky to make a 10% return in the public markets e.g. S&P 500. Therefore, if I can get a 9% return with 25% downside protection, I should be aggressively investing in such a security all day long.
Of course, stocks are more volatile than indices, and each investor has a different outlook for the markets. You just have to decide where you think the market is going and invest within your investment parameters. Don’t let anybody who isn’t in your shoes tell you where to put your money, unless they have a fiduciary duty to be your financial advisor.
Have a look at the various scenarios below.
I believe there is a 80% chance American Airlines will return +/- 25% over the next twelve months. Given that I only believe there is a 20% chance American Airlines will decline by more than 25%, I’m willing to invest money into this note to get a high probability 9% return. If I’m wrong, then at least I will have a 9% buffer to make up for my +25% losses.
Here are some highlights from boutique research firm, S&P Capital IQ that was send to me by my Citi Wealth manager. I ended up investing $15,000 into this structured note, based on my normal cadence of investing $5,000 – $20,000 a month in various securities while paying off some rental mortgage debt (Related: Pay Down Debt Or Invest?). I am unwilling to go naked long American Airlines due to the stock’s volatility.
Once you accumulate an amount of money you’re happy to live on for the rest of your life, your goal is to protect it at all costs. Looking to hit triples and home runs is financially irresponsible. Instead, shoot for singles and doubles, which to me, means earning 2-4X the risk free rate of return.
Single stock structures notes tend to be riskier than index structured notes. But thanks to tremendous liquidity in the bull market, I can only find index structured notes providing 4-5% annual returns with 20% downside buffers or barriers. That’s within my target return profile, but the lockup periods are generally five years. Therefore, I’ve decided to go a little further out on the risk curve to improve returns while shortening the lockup period.
Think of structured notes like an investment insurance option. You hope you don’t have to use the insurance (the security does much better than expected), but if you do use it, you’ll be sitting much prettier than those who have naked exposure.
If you don’t have a regular investment contribution habit, it’s time to get started. There’s an endless selection of investments to choose from. Just make sure your investments are appropriate with your objectives. Don’t invest in anything you don’t understand either. I hope this post helps educate you on how structured notes work.
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About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $210,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2021 and beyond.