RIA redeems note, splits proceeds to get yield, equity returns in anticipation of lower growth

By Emma Trincal

New York, May 19 – Eight year into a bull cycle and with interest rates historically low, advisors continue to struggle to meet their clients’ needs for both capital appreciation and income in a toppish market, which continues to break new highs amid growing political risk both abroad and in Washington.

“Investors want to keep their exposure to equities but with some protection. At the same time, they also need income,” said Jerry Verseput, president of Veripax Financial Management, LLC.

“You have to strike the right balance between giving them yield and the opportunity to make a good return if the market slows down.”

Lower expectations

With the averages near all-time highs albeit the recent sell-off on Wednesday, fewer market participants anticipate double-digit returns in the next few years. But the appetite for equity gains remains for as long as bulls are in control.

Being able to lock in a fixed-return that may compete with expected modest stock returns and current low yield is a win-win strategy, he said.

“If you can also participate if stocks continue to go higher it’s even better.”

Verseput, who likes to use structured notes, said he just put together a strategy that he hopes will allow him to combine income and equity exposure in his portfolio.

He recently put back to the issuer an absolute return note and is reinvesting principal and gains into two different notes, one for the market exposure the other for the income.

Put back with profit

“I had a five-year Credit Suisse absolute return worst-of on U.S. indices, which was up 24% after three years. I just redeemed it back to Credit Suisse to lock in a 24% gain,” he explained.

“I still had two-years left. But with U.S. stocks now so high we decided to lock in the gain we had.”

Credit Suisse AG, London Branch’s 0% absolute return barrier securities due May 3, 2019 linked to the Russell 2000 index and the S&P 500 index, offered 1.125 times the gain of the worse performing index, according to a 424B2 filing with the Securities and Exchange Commission. He bought the notes on April 2014.

If each index finished at or above the 55% knock-in level, the payout would be par plus the absolute value of the worse performing index.

Otherwise, investors were fully exposed to the loss of the worse performing index.

Splitting

Verseput has already decided where to reinvest the funds on Monday.

“The proceeds will be split between two six-year notes from Barclays, both worst-of linked to the S&P 500 and Russell 2000, and both having principal barriers that would have been more than sufficient to provide protection through the 2008-2009 financial crisis,” he said.

Using backtesting on the two indexes, he found that the worst performance of the two indexes over a six-year rolling period was 19%. Verseput said he obtained much more than that in protection on his notes.

Income

“The income note is a contingency note with a barrier and contingency yield that I think is high enough to provide equity-like returns. I don’t think there is much upside left in the U.S. markets,” he said.

Barclays Bank plc’s callable contingent coupon notes due May 25, 2023 linked to the lesser performing of the S&P 500 index and the Russell 2000 index pay a quarterly coupon of 8% per year if each underlying component closes at or above its 65% coupon barrier on the observation date for that quarter.

The notes are callable on any contingent coupon payment date beginning with the third observation date.

The payout at maturity will be par unless either underlying component finishes below its 65% barrier level, in which case investors will lose 1% for each 1% decline of the worse performing component.

Verseput said he does not expect high equity returns looking forward, which is why 8% provides an attractive yield.

The U.S. equity market is overbought, he said. Markets may continue to rise but at a milder pace or at some point simply correct, hence the need for protection.

A sign that market values are stretched, he said, was the price-per-earnings ratio of the S&P 500 index at 25.

“Historically, the markets have never done well when the P/E is above 20,” he said.

Other reasons to be prepared to a slower market were the expected rise in interest rates and the political uncertainty around the Trump Administration’s ability to push forward its pro-growth agenda in the midst political headlines.

“I’m looking for a few things...First, I want downside protection to lock in gains; second, I’d like to keep up with the market. A fixed return can work out if we’re headed to lower, single-digit returns. Finally, if the market continues to rise, I want to participate in the upside,” he said.

Minimum return

In order to satisfy these three requirements, Verseput is planning to buy with the rest of the proceeds a second note that offers a target return with no cap.

“My second one is an equity-oriented note with a digital return and a 30% geared buffer. It pays 44% in digital return, or 7.33% a year, and there’s no upside cap if the indices are higher than 44% at expiration,” he said.

Barclays Bank’s 0% buffered digital plus notes due May 25, 2023 linked to the lesser performing of the S&P 500 index and the Russell 2000 index, pay par plus the greater of the fixed payment of 44% and the index gain of the lesser performing index, according to a 424B2 filing with the SEC.

The payout at maturity will be par unless either index finishes below its geared buffer level, 70% of the initial price, in which case investors will lose 1.4285% for every 1% decline of the worst performing fund beyond 30%.

Verseput summarized his strategy for what he expects to be a low-return equity market environment.

“By utilizing an income note and an equity-oriented note, I can generate a healthy amount of current income, and dial in the exact amount of equity exposure versus income requirements that clients want or need.

“I’m finding that many clients do not think the U.S. market will sustain an 8% average return for six years, so the income note seems to be more popular,” he said.

Credit Suisse Securities (USA) LLC was the agent for the Credit Suisse notes.

The Cusip number was 22547QLG9.

Barclays is the agent for both Barclays’ notes.

The Cusip number for the callable contingent coupon notes is 06741VV58.

The Cusip for the buffered digital is 06741VV66.

Both deals will price on Monday and settle on Thursday.

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