Many investors review their asset allocation to determine if their portfolio meets their risk and return objectives. In this current environment, the conundrum we often hear from investors is:

1) The desire to manage risk may have inhibited their ability to achieve their expected returns due to the low-interest rate environment.

or

2) The desire for higher returns may have caused them to take more risks than they are willing or able to absorb.

Finding the perfect balance requires disciplined rebalancing and fine-tuning of a portfolio. Diversification has also been touted as a key attribute of portfolios able to withstand dynamically changing investment environments.

Structured notes can also be an effective alternative investment and complement traditional stocks and bonds. When used as part of a diversified portfolio these investments can help achieve an attractive risk-adjusted return.  There are a variety of structured notes with differing terms and payoff profiles. Some are relatively simple to understand while others can be complex and are only suitable for sophisticated investors. Working with an advisor to understand the terms, the payoff profiles and the risks are essential before purchasing these investments. Together, you should seek to select those investments that best reflect your view of the markets, your liquidity needs, your ability to take risk, and your time horizon.

Structured Notes 101

Structured notes are debt securities issued by financial institutions. Within these securities are options and derivatives that are packaged together to create a payoff profile that includes a return and downside expectation. The creditworthiness of the issuer is vital and therefore we prefer to only purchase notes issued by the 6 largest Canadian banks.

There are five core elements to understand the payoff profile of a structured note:

Underlying Asset: The performance of the note is linked to the performance of an underlying asset which can be an index, a basket of stocks, or even a single stock.

Maturity: The term of these notes typically ranges from 3 years to 7 years. However, this does not mean the investor is locked in for the entire period. Investors can sell the note before maturity in the secondary market.

Upside Returns: The returns from notes usually come in two forms:

Fixed Returns: These notes provide a guaranteed coupon and distribution payment with no necessary conditions to be met.

Variable Returns: These notes provide a return that depends on the actual performance of the underlying asset.

Typically, all things being equal, fixed return notes have lower payoff profiles compared to variable return notes. This is accepted by investors who want the assurance that a distribution will be made.

Downside Protection: Notes may offer differing degrees of protection. There are three main protection categories:

Principal Protected offers a full guarantee on the principal at maturity.

Buffers offer partial guarantees on your principal. For example, a note with a 20% buffer will protect the investor from the first 20% drop at maturity. Therefore, if the underlying asset was down by -30% at maturity, the investor would only face a 10% loss (30%-20%).

Barriers only offer protection up to a certain level, and if breached will not offer any protection. For example, a note with 30% barrier protection protects the investor from the first 30% drop at maturity. However, if the underlying falls by more than -30%, the investor would participate in the full downside. Hence, if the underlying was down by -40% at maturity, the investor would lose -40%.

Suffice to say, all things being equal, a higher protection level will decrease the fixed or variable return. It is also important to remember that these protections are only guaranteed at maturity. If the investor decides to sell before maturity, the gains/losses will be based on the pricing in the secondary market.

Early Selling Charges: Most structured notes do not have the annual MERs that are commonly embedded into products like mutual funds. However, some notes will penalize you with an early selling fee if you liquidate before a specified time frame. In our experience, the required holding period to avoid an early charge is between 9-12 months.

Are Structured Notes right for me?

There are numerous variations of notes. The permutations are infinite when combining the five features of asset type, maturity term, return profile, protection type, and required holding period. For this reason, we recommend investors work with an advisor who can help guide them through the notes that will match one’s investment thesis with an appropriate risk and return profile. Structured notes will not be suitable for all clients.  Speak to us to review whether structured notes may be appropriate based on your objectives.