High yield investments are still out there with only slightly higher risk than GICs and money market funds
In the past 18 months, there has been a big migration of investment dollars to money markets, guaranteed investment certificates and short-term bonds — five per cent yields will do that.
The problem is that they are now heading in the other direction. I expect Canadian money market rates to be paying well under four per cent by year-end and could be less than three per cent a year from now.
As we shift from an investment environment of rising rates to one of declining rates, how do you keep investment yields high without taking on too much risk?
An interesting investment option can be found today that is paying yields in the eight per cent to nine per cent range on investments we believe are only slightly higher risk than GICs and money market funds. These are investments that are offered by most of the big banks in Canada, but also available through some advisers. They are not marketed aggressively, but hold great appeal for many of our clients.
A current example is as follows: it’s offered by a Big 5 bank (but available more broadly); pays 8.64 per cent per annum, with interest paid monthly; can be called at par (the price you paid) at any point from two years to seven years, but you keep all interest; can be called after two years if the index (in this case, Canadian pipelines) is up more than five per cent from the purchase date; can be invested in any type of investment account: registered, non-registered, corporate, etc.; priced daily and can be sold at any time — it is not locked in — but there isn’t a secondary market, so you can’t buy the note after it closes; and this specific note is available until Sept. 11.
What’s the catch?
Like all investments, there is a connection between risk and reward, although we believe the reward with this investment is much higher than the risk, especially when compared to money market and GIC investments at this point in time.
This note is connected to a Canadian pipeline index that holds four of the sector’s largest companies in Canada: Enbridge Inc., TC Energy Corp., Pembina Pipeline Corp. and Keyera Corp.
The main risk comes into play if this index value is down by 30 per cent or more since you won’t receive interest for those months that it is down that much. In addition, at the end of seven years, if the note has not been called and the index is down, say, 35 per cent, you would only receive 65 per cent of your original investment. If the index was down 25 per cent (less than the 30 per cent cushion), you would receive 100 per cent of your original investment.
What are the chances of this happening?
A review of the past 21 years, including 3,497 rolling seven-year periods, shows there wasn’t one that had a 30 per cent loss or more. This means that 100 per cent of the time from 2003 to 2024, all investments would be fully redeemed. It doesn’t mean you can’t lose money, especially if you sell before they are redeemed, but if held to redemption, it is highly unlikely.
If we focus on any months when the index was down more than 30 per cent (such as March 2020, the beginning of COVID-19), we find that this is a very rare occurrence. In our review, in a ‘bad’ scenario, you would have one month out of seven years where interest wasn’t paid. This would still mean an average interest yield of 8.54 per cent, significantly higher than GICs or money markets.”
One other risk is that while you can sell the notes at any time, there is no certainty the price will be up when you sell. There have certainly been times where conservative notes could easily get a price of $105 on the upside, but also $85 on the downside. The ability to sell daily is a liquidity benefit, but you generally want to hold these investments until they are redeemed.
The bottom line is that this is a far better investment in most scenarios than a locked-in GIC from a risk/reward basis and, unless it is for shorter-term purposes, this investment could be better than money market funds. It is a little higher risk, but the rewards are much higher.
The example I have provided here is one of dozens of structured notes available. Some pay much higher yields, are structured differently and use different indexes or equity references, but we think that the more conservative end of these notes is the sweet spot.
From a tax perspective, these notes are treated as interest income and would ideally be held in a tax-sheltered account if possible.
There is a mutual fund of structured notes through Purpose Investments Inc. that is structured for tax purposes as capital gains. This is a big advantage for taxable accounts, but a fund of structured notes is not the same as owning an individual note.
On the positive side, the fund has greater diversification, especially in terms of reference indexes. There is also an opportunity to effectively buy notes that are underpriced if timed correctly in a fund, where you can’t buy individual notes after their initial sales period has ended.
The negative is that you lose the ability to target low-risk notes with the goal of holding them until they are redeemed. Within the fund, there is a wider range of risk among the individual notes. As a result, you may still own individual notes in taxable accounts when you want to have tighter control over the risks.
We know there is an overflow of funds in GICs and money markets due to the higher interest rates of the past two years, but there are now better options for conservative money, and this is one.
Reproduced from Financial Post, September 4, 2024 .
