What's Ahead:
- The Federal Reserve increased its policy rate by just a quarter point in March following financial market turmoil, rattling stocks and causing a jump in bond market volatility
- For the first time this cycle, rate cuts are expected soon, introducing a new risk for investors to consider
- A portfolio strategy including structured notes can harness volatility and offer diversification from heightened equity risk
Fears of another global financial crisis have quickly come to the forefront following the failure of SVB Group (also known as Silicon Valley Bank) and Signature Bank out of New York in early March. Another major domino fell overseas with UBS being forced to take over embattled Credit Suisse the following week.
Despite enhanced volatility in both the stock and bond markets and worries that systemic financial problems are brewing, the Federal Reserve continued down its path of increasing interest rates. Making jitters worse on Fed Day was an unexpected announcement from Treasury Secretary Janet Yellen that there are no plans to issue blanket FDIC insurance for uninsured deposits across the banking system.
The Dovish Hike and Where Interest Rates May Be Headed
It was dubbed the “dovish hike” by market strategists, but call it what you will, short-term savings rates are now at the highest levels in more than 15 years. There’s more to the story, however. For the first time during this monetary policy cycle, rate cuts are priced in throughout the next two years, according to data from the CME Group. Is the fastest increase in the fed funds rate in the past 40 years nearly over? Maybe so.
One More Policy Rate Hike Expected in May, Capping Off a Historic Climb in the Fed Funds Rate
Fed Funds Futures: Rate Cuts Expected, Beginning This Summer
As it stands, the fed funds target rate is now 4.75% to 5%. Comparatively, you can earn just a smidge more by taking on a modest amount of corporate creditrisk by owning short-term investment-grade corporate bonds yielding about 5.3%. High-yield credit, which has a significantly longer duration (more interest rate risk) features a yield-to-maturity under 9%, according to the St. Louis Federal Reserve. As for the stock market, the S&P 500’s earnings yield (which is the inverse of the price-to-earnings ratio) is below 6%, using FactSet’s latest figures.
A New Risk Is Born
So, it’s a no-brainer to just park money in cash to collect that risk-free 4.75% rate, right? Not exactly. You see, investors must consider reinvestment risk with their cash. It’s the notion that while cash is appealing today – and certainly free from equity risk – getting back into the market in, say, a year could make hanging out in cash today a misstep. After all, bond yields could be lower 12 months from now and equity prices could be higher. That means parking money in short-term securities increases the need to “time the market” because it is not a long-term solution. Even the most senior money managers avoid trying to pinpoint the “right time” to reinvest. Instead, we can choose a solution that balances both sides of the risk coin with long-term investing in mind.
Money Market Funds’ Net Assets Soar Following the Fed’s Rate Increases
What’s different about today’s investing landscape is that the volatility of a balanced portfolio is very high considering that for much of the past two years, stocks and bonds have moved together. Treasury bonds have not offered a diversification benefit for risk-conscious investors. What’s more, volatility in the fixed income market is at the highest levels since the Great Financial Crisis, unnerving retirees who just want to protect their principal and, ideally, outpace inflation.
Treasury Market Volatility Notches its Highest Reading Since December 2008
All this March Madness on Wall Street begs the question: Is it worth it to accept equity risk given the alternatives offered in the bond market? Better yet, why not take advantage of today’s elevated volatility by including structured notes as part of a portfolio?
Structured Notes: an Alternative to Equity Risk
You might wonder how a structured note works. The Halo Journal highlights many strategies to fit an investor’s return objectives, risk tolerance, and time horizon, but the upshot is that an income note linked to the S&P 500, for example, delivers fixed coupon payments and downside protection. That combination can potentially generate positive returns with a higher yield compared to the market’s dividend rate even if equities endure more troubled times ahead.
The Hedged Equity Strategy
To combat heightened equity risks in today’s markets, our team constructed a portfolio blueprint advisors can put to work for their clients. We call it the Hedged Equity Strategy, and it addresses the reality that stock market volatility and steep moves in the rates market are correlated to a level not seen in decades.
The Hedged Equity Strategy simply takes a portion of both the stock and bond slices of a typical diversified portfolio and re-allocates it to low-cost structured notes. That way, the portfolio’s yield increases, and risk related to equities and credit drops.
The goal here is to produce better returns and a better investment experience, all while reducing volatility. We find that advisors who have put this strategy to work have helped clients stick with their investment plans from the emotional side of the ledger, because there is market risk protection to calm their nerves.
Is This the Time Right for Annuities?
Getting back to the expected drop in short-term interest rates, now could also be an ideal time to lock in a favorable income stream provided by a low-cost annuity. For years, annuities lost out to the stock market, which was garnering robust returns amid the Fed’s zero-interest rate policy.
Now, though, rates are higher and stock index funds are going through a rough patch. Could the next decade look different compared to the easy-money policy period of the 2010s? Nobody knows for sure, but there’s little doubt that new challenges for policymakers are front and center, and there is no quick fix. So, today’s higher yields and uncertainty about the future make annuities all the more attractive for diversifying how equity exposure works within portfolios.
The Bottom Line
Recession fears ticked up in a big way in March. Financial market troubles shifted investors’ mindsets from 2023 optimism to the reality that volatility is not retreating all that quickly. Structured notes and annuities are two types of protective investment solutions that can help advisors and retail investors weather the storm.
Please see our other important disclosures.
