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Structured Notes – Innovative Alternatives to Mutual Funds and ETFs

May 27, 2020

Do you wonder if buying and holding mutual funds and exchange traded funds is the best strategy for your portfolio? Structured notes provide an opportunity for enhanced return potential and risk reduction compared to an underlying basket of stocks. This basket of stocks is called the reference portfolio. A structured note is an obligation of the note issuer to pay the investor based on the performance of the reference portfolio.The reference portfolio is typically a stock market index or an exchange traded fund (ETF). Occasionally the reference portfolio is a single stock.Structured notes can meet the needs of a wide spectrum of investors, from investment cowards looking for GIC alternatives to bold investors looking to capitalize their outlook for a neutral (sideways), bullish (positive)or bearish (negative) market.

Types of structured notes chart

Structured notes do require investors to have a basic understanding of the protection, growth,and income features of the notes they invest in. With the help of their advisor, most investors can understand the basic features outlined in the investment literature for a particular structured note.

Protection Features

Many notes have features to protect the investor’s investment. Common protection features include:

structured note reaction chart principal protected
Principal Protection: The issuer promises to return at least the investor’s entire principal at maturity.
structured note reaction chart barrier protection
Barrier Protection: The purpose of barrier protection is to protect the investor from a moderate decline in the reference portfolio. The issuer promises to return at least the investor’s entire principal when the reference portfolio is above a barrier.For example, a note with a 20% barrier will return the investor’s entire principal if the reference portfolio is larger than -20%.Below the barrier, there will be no protection.

structured note reaction chart buffer protection
Buffer Protection: The investor experiences no loss if the reference portfolio is above the buffer at maturity. If the reference portfolio is below the buffer at maturity, the investor receives the return of the reference portfolio and the amount of the buffer.For example, a note with a 10% buffer will return -5% if the buffer the reference portfolio is down 15%.

Growth Features

It is common for notes to have returns that are accelerated. For example, a note with 200% acceleration would return twice the return of the reference portfolio and maturity.

structured note growth feature

Boosted Return Notes

A Boosted Return Note will post the investor’s return to a set level if the return of a reference portfolio is positive or in some cases even slightly negative.For example, the graph on the right shows a note which would boost the investor’s return to 30% if the reference portfolio returns between -10% and +30%.Boosted return notes are usually not capped, so if the reference portfolio is above the boost level the investor receives the return of the reference portfolio. Boosted return notes often have a barrier protection feature as well.

structured note boosted returns

Auto-callable Notes

An Auto-callable Note will provide a fixed return if the reference portfolio is positive even by a penny on an observation date, which is usually the anniversary of the note issue. Most notes will have between three and five observation dates. If the reference portfolio is positive on the observation date the note is called automatically, and the investor receives their initial investment as well as the fixed return. At maturity, if the note has not been called, the investor receives the return of the reference portfolio. Most auto call notes have a barrier protection feature, in which case it is possible the investor will not lose money at note maturity if the reference portfolio is only moderately negative.

As an example consider the table to the left representing an auto-callable note with a three year term and three observation dates. If the reference portfolio is one penny positive on the 1st observation date, the note is automatically called and the investor receives a 9% return. If the reference portfolio is positive on the 2nd observation date, the investor receives 18% and the note is called.On the 3rd and final observation date, the investor receives a 27% return on their investment if the reference portfolio is positive; if the reference portfolio is negative, the investor receives the return of the reference portfolio, possibly moderated by protection features of the note.

structured note auto callable chart

Income Notes

Income Notes include Return of Capital Notes (ROC Notes) and Variable Return of Capital Notes. Typically these notes provide a regular coupon (payment to the investor) with yields significantly higher than preferred shares, bonds, or GICs. The notes are linked to a reference portfolio with barrier protection; at maturity, if the reference portfolio is above the barrier the investor receives their initial investment back; otherwise they receive the return of the reference portfolio.

What are the Risks? 

In addition to losing money based on the terms of the note if the reference portfolio does poorly, the likelihood the investor will get paid when the note is redeemed is dependent on the financial health and creditworthiness of the issuer. For this reason, notes are issued in Canada mainly by banks including:

• Bank of Montreal • Bank of Nova Scotia • National Bank • TD • CIBC • RBC

This article is intended to provide education so that investors can understand the basic concepts of structured notes. However, every structured note is different, and the investor should read or understand the terms of any specific note before investing in it.

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