So here we go again, short-term interest rates have been reduced by one and a quarter percent over the last few months by the Bank of Canada and there could be one last rate cut by the end of the year. This has helped mortgage borrowers as they can get more attractive five year borrowing rates, conversely, lower interest rates hurt savers by decreasing the income they can expect as we now see five year GIC rates dropping below 4%. This falling interest rate world has also been very supportive for dividend paying stocks and bonds, as investors have been getting juicy yields and seen their capital grow substantially over the last few months.

But what do falling interest rates mean for those investors that hold structured notes through our Income Note Strategy?

First, a refresher. Income notes pay monthly interest payments to investors as long as the sector of the stock market the note is tracking does not fall by more than 30% from the issue date of the note (-30%, in this case, is the protection level). So what does this mean? It simply means that investors can generate income from market sectors that are rising, moving sideways or that fall up to 30% (or 40% or 25%, respectively, if it is deemed a better risk/reward level). Monthly interest payments are not guaranteed and will be missed if the stock market sector being tracked falls below the protection level, which is why we do expect and budget for some missed coupons, i.e. interest payments. The graph below shows a note that we invested in which tracks the travel sector - the price of the note is the blue line, and the starting price is the black line, and interest payments are only made when the blue price line is between the red and the black line, and despite the fact that this note missed some coupon payments it was still an attractive note to hold.
 

Source: bmonotes.com

What does the current yield environment mean for investors in our Income Note Strategy?

We are willing to own notes if they have a coupon 4 to 5% higher than a five year GIC. Accordingly, we are currently only investing if a note pays 8 to 9%, and if a five year GIC drops to 3% this target will move to 7 to 8% for the strategy. As mentioned, we also know that there could be times when interest payments won’t be paid to an income note investor and we mitigate the risk of missed coupons and overall risk accordingly:

• We own notes in three to four diverse sectors
   
• We buy into sectors that have recently experienced sell-offs, which should increase coupons paid and lowers the risk of the entry point
   
• Most importantly, we meet regularly to ensure that we are investing your money prudently and with the care it deserves, which also means that we "eat our own cooking"

If interest rates continue to move lower it does not necessarily mean income notes will become unattractive for our strategy, as market fluctuations typically increase note coupons and are more of a factor than current short-term interest rates. However, if notes do become unappealing we will deploy that money into cash and wait for better opportunities, wherever they present themselves. So if you are one of our Income Note Strategy investors and we move to cash (reminder, we do not charge fees on cash) that will temporarily reduce your income.

Please keep in mind that we are not making predictions, we are communicating current market conditions and preparing income note investors for a possible shift to other opportunities if we see unattractive coupons on income notes.  For context, the graph below shows how coupons or monthly interest payments have varied over the last three years, averaging an annualized 10.26%, with a high of 12% and a low of 8%. In short, we still like the strategy.
 

Source: R&R Investment Partners. January 2021 through June 2023: BMO Global Structured Products; July 2023 through October 2024: BMO Global Structured Products, CIBC Structured Notes, National Bank Structured Solutions Group, Scotiabank Investor Solutions Group. These calculations and projections are for demonstration purposes only. They are based on a number of assumptions and consequently actual results may differ, possibly to a material degree.

Let us know if you have any questions, and don’t hesitate to reach out to one of us if you’re not currently invested in the Income Note Strategy – we can discuss with you if it’s a good fit within your financial plan.

Randy, Ian and Harrison