Structured notes can offer payout profiles that are hard to create with traditional bonds, mutual funds, or even stocks. At the same time, they can be complex and carry risks that your clients need to learn before investing.
In this article, Wealth Professional Canada will shed light on everything you need to know about structured notes. We'll discuss what happens to this type of investment at maturity and how they are taxed in Canada. You can also find the latest news on structured notes when you scroll to the bottom of the page!
Structured notes are investment products that behave in some ways like bonds while tying performance to another asset. That asset can be:
Fundamentally, structured notes are hybrid securities. They combine a fixed income component with one or more derivative components. The fixed income portion behaves like a bond or deposit issued by a financial institution. The derivative portion links the payoff to one or more underlying assets.
Structured notes also follow a formula. The final outcome on the maturity date depends on whether the note includes principal protection or the:
Because the payoff is defined in advance, investors would know how the return will be calculated, even though the actual result will only be known at maturity. Structured notes can be designed to offer:
For financial advisors, the attraction lies in the ability to combine bond-like features with equity-linked or other market-linked potential. Watch this video to learn more:
Find out how you can use structured notes to customize client portfolios when you read this article!
Structured notes can take many forms, but most draw on the same basic building blocks. Here are two examples:
Principal protected notes (PPNs) combine a bond or deposit with a derivative, such as an option on an index. Most of the money goes into the bond piece. This aims to return the full principal at maturity. The remaining amount funds the derivative, which provides upside exposure.
For instance, a five-year principal protected note could invest most of the capital into a five-year bond. The rest could purchase options linked to a broad equity index.
If the index rises, the options pay out and the investor receives a return on top of the principal. If the index falls, the investor still receives the principal back at maturity, assuming the issuer does not default.
Principal at risk notes (PARs) do not guarantee full repayment of principal at maturity. They often offer higher potential returns to compensate for this extra risk.
An investor who wants to maximize growth potential might choose a note that amplifies the performance of an index. The note can include a protective barrier up to a certain decline.
If the index remains above that barrier, the investor receives an enhanced return. If the index falls below the barrier, losses can extend into the principal.
Structured notes are complex products. They combine debt and derivatives in a single wrapper, and the payoff often depends on several moving parts. Investors need to understand how the bond and derivative components interact and how different market paths affect the result at maturity.
Because of this complexity, structured notes are often created for sophisticated investors. Investment banks frequently design these products for hedge funds and institutional investors that can analyze the structures in detail.
That does not mean your clients will never see them. High-net-worth individuals and other experienced investors might be drawn to structured notes for several reasons. Let's use three sample scenarios:
1.) Client A is enjoying his retirement. He wants regular income to help cover his living expenses, but he also wants to protect most of his capital. A structured note that pays periodic coupons and offers partial or full principal protection might suit his needs.
2.) Client B is a cautious investor who is not happy with low deposit or government bond rates but does not want to take full equity risk. She might consider a structured note that offers a higher potential coupon than traditional bonds.
3.) Client C is focused on growth and is comfortable with market risk. He might look at an accelerated or leveraged structured note that multiplies the gains of an equity index. If the index stays above the barrier, he can benefit from enhanced upside. If the barrier is breached, he accepts the downside risk.
Structured notes can also help with portfolio construction when your clients want:
At the same time, structured notes might not suit every retail investor. The products are often hard to understand, difficult to sell before maturity, and exposed to issuer default. When considering structured notes, a financial advisor should pay attention to their clients':
The product should fit a clear objective, rather than act as a novelty in the portfolio.
Aiming to be a top financial advisor in Canada? You must guide your clients when investing in structured notes and see if this investment type fits their goals and risk tolerance.
The most important date for a structured note is the maturity date. Investors are generally expected to hold the note until this point.
Although many structured notes are linked to public markets, they usually do not trade on deep secondary markets. The issuer is often the only party able to redeem the note before maturity. If your clients need to sell early, they might face:
Because of this, structured notes should be used with money that your clients can commit for the full investment period. At maturity, the payoff is determined by the rules set out when the note was issued. The outcome depends on:
Protection features also matter at maturity. Hard protection creates a buffer. Losses apply only once the underlying asset's decline goes beyond the protection level. Losses then start from that point onward.
As for soft protection, it usually means there is a set level for the underlying asset. If the asset falls below this level, the investor becomes exposed to the entire loss, not just the amount past the barrier.
In every case, issuer risk remains. If the issuer files for bankruptcy or cannot meet its obligations, the structured note can become worthless, even if the underlying asset performed well. Your clients are exposed to the credit risk of the issuer for the full life of the note.
Because the yield is only known at maturity, you should prepare your clients for a range of outcomes. Walk through different market scenarios and show how each would affect their final payoff.
In Canada, structured notes are usually taxed as interest income. That means gains are taxed at ordinary income rates, not at more favourable capital gains rates.
For many investors, this treatment can reduce the after-tax appeal of structured notes when held in non-registered accounts. A similar pre-tax return in a traditional security that generates capital gains might leave more in your clients' pockets after tax.
Structured note income is commonly reported on T5 slips, similar to interest from other financial products. This reporting can simplify tax filing but does not change the rate at which the income is taxed.
One way to address this drawback is to hold structured notes in registered accounts where interest income is sheltered or deferred. For example, some investors might choose to place structured notes inside:
When structured notes are placed in these accounts, investors can reduce or remove the immediate tax burden on the interest income. As a financial advisor, you should still consider contribution limits, withdrawal rules, and overall asset mix across all accounts.
Tax treatment can be complex and can change over time. It is critical to review each issue's tax disclosure and encourage your clients to seek tax advice that suits their situation.
Structured notes bring together bond-like features and derivative payoffs in one security. Income-focused households can look for notes with regular distributions and some degree of protection. Growth-oriented investors can consider structures that amplify upside or take views on specific markets, sectors, or assets.
At the same time, structured notes are complex, often illiquid, and carry credit risk from the issuer. Some structures include protection levels, while others expose your clients to full downside risk. The final return is unknown until maturity, even though the formula is fixed in advance.
As a financial advisor, the right conversation can help your clients see both the potential benefits and the risks. This, in turn, allows them to decide whether these products deserve a place in their long-term strategy.
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