After a relatively calm year in 2021, market volatility has increased this year. The Chicago Board Options Exchange Volatility Index (VIX), a widely used measure of market volatility, has been higher in 2022 as uncertainty about economic activity has risen. One reason for this volatility has been the rapidly rising inflation environment. These price increases can influence the current economy, actions by the Federal Reserve, and sentiment of future growth. As a result, many of the historical assets used for protection like bonds have not worked in this environment. Bonds have recently had their worst quarter in the last 20 years and are down 9.37% year to date1.
At Gradient Investments (GI), we have been negative on the bond market for quite some time. As a result, we have looked to alternative approaches to provide the protection from market declines. One of those solutions has been the use of the Gradient Structured Note Series.
The Gradient Structured Note Series has two types of portfolios: Growth and Income. The two growth portfolios are the Buffered Index Portfolio2 and the Dual Directional Buffered Index Portfolio3. The purpose of the growth portfolios is to provide a pre-defined level of downside protection (buffer). Growth notes also come with a pre-defined maximum upside participation level (cap). The Gradient Designed Income Portfolio4 has an objective of providing a recurring income stream through coupon payments. The payments are based on indices and both coupons and principal returns have pre-defined types and levels of protection.
Gradient Structured Note Portfolios are actively selected by the portfolio management team and are exclusive to Gradient Investments. The level of upside participation in growth notes or coupon levels for income notes are determined by various parameters. These parameters include:
- The level of protection: The greater the protection, all else equal, the lower the cap or coupon
- The type of protection: A buffer versus barrier level of protection affect the cap/coupon levels
- The time to maturity
- The index/indices used
- The current level of volatility in the market: All else equal, higher volatility = higher caps and coupon levels
The buffer feature in the growth portfolios help alleviate some concerns about a market pullback by providing a level of protection when markets decline. Historically the buffers on the structured note growth portfolios have been between 10% and 20%. Investors will experience losses beyond these pre-defined buffer protection levels.
With the Dual Directional Portfolio, investors can potentially have positive returns even in a negative market environment. If the index performance is negative but within the buffer range, the investor receives the inverse or absolute value of the index. The possibility of making money in a down market is a powerful feature. The chart below is a hypothetical scenario of the Dual Directional Portfolio with the index returns and investor returns. The green box shows the case of a negative index return providing positive investor returns.
The Designed Income Portfolio is an attractive option for investors looking for recurring income. Low bond yields and negative bond performance to start 2022 can leave traditional bond investors scrambling for higher yields. The Designed Income Portfolio uses the same well-known indices, like the S&P 500, combined with pre-determined levels of protection for both the coupon payments and principal return. The primary difference is that investors in the Designed Income are looking for recurring coupon payments compared to potential upside participation from Growth notes.
In summary, as investors look for protection outside of the bond market, the GI Structured Note Series offers investors an alternative approach to asset protection and return potential. Whether the objective is recurring income or potential for upside participation in rising markets, the Gradient Structured Note Series has potential solutions to fit their needs.