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Structured product

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A structured product is defined by the Canadian Investment Regulatory Organization (CIRO) as a "market-linked investment that is packaged as an alternative to a direct investment in the underlying security or basket of securities".[1] CIRO includes principal protected notes and principal at risk notes in their definition, but banks also sell market-linked GICs under this general title.

Banks and brokers like to sell structured products; for example, as of April 2025, one investment bank lists over 6000 existing structured notes on its website.[2] Another one lists over 2000 index-linked GICs, over 1000 principal protected notes and over 9000 principal at risk notes.[3] Larry Swedroe writes that structured products "have attributes that make them more attractive to the seller than the buyer", explaining why banks like them, but investors should avoid them.[4]

One academic paper, which looks at over 1500 principal protected notes from Canada and the UK issued between 2003 and 2015, remarks that is is difficult for "retail investors to value structured products and to assess the unobserved premiums charged by the issuers. More importantly, the complexity of some products limits the ability of a retail investor to assess the risk, even with adequate information disclosure".[5] For the over 1000 Canadian products studied, the underlying assets returned more than the structured product 82% of the time when dividends are taken into account.[5]

The title of a recent Globe and Mail article explains how these products are sold: "Structured notes are designed to exploit cognitive and emotional investor biases".[6] This was inspired in part by an academic paper which looked at specific structured products in the US market, calculated that the expected return was less than 0% and then went on to write:[7]

...there is a dark side to the ability to create instruments with tailored payoffs. If some investors misunderstand financial markets or suffer from cognitive biases that cause them to assign incorrect probability weights to events, financial institutions can exploit the investors mistakes by creating financial instruments that pay off in the states that investors overweight and pay off less highly in the states that investors underweight, leading the investors to value the new instruments more highly than they would if they understood financial markets and correctly evaluated information about probabilities of future events. In addition, the ability to create instruments with almost any payoffs implies that there are few limits on the complexity of financial instruments. A recent theoretical literature explores equilibria in which firms shroud some aspects of the terms on which their products are offered in order to exploit uninformed consumers ... and strategically create complexity to reduce the proportion of investors who are informed ...

Market-linked GICs

Main article: Market-linked GIC

Market-linked guaranteed investment certificates are a type of structured product that combines the security of principle of a GIC with some participation in specified equity market returns. They are also known as index-linked GICs.

Market-linked GICs appeal to investors who would like to enjoy potentially higher returns (compared to normal interest-bearing GICs), but are afraid to lose money in the stock market. In other words, these products "appeal simultaneously to our greed and our fear"[8], which may help explain their popularity. They are typically sold in bank branches.[9]

Principal protected notes

CIRO defines a principal protected note (PPN) as a "financial instrument where the return is linked to the performance of a specified underlying security or underlying basket of securities and at maturity the investor receives as a minimum, the initial amount invested".[1]

What they are

PPNs are debt obligations of the issuing bank or credit union. Instead of paying fixed coupons, their return is linked to that of an underlying asset through formulas defined in the offering documents. They are comparable to index-linked GICs, but typically come without the CDIC coverage.[10] Instead, the guarantee on the capital -- a guarantee which is only available at maturity -- is only from the bank or other issuer, relying on its creditworthiness. If the issuying bank becomes insolvent, investors might only get back cents on the dollar, like happened in the US to people who purchased PPNs from Lehman Brothers in 2008.[11]

PPNs are available on a wider range of underlying investments than market linked GICs, including stock indices, custom baskets of stocks (see example below), but ranging up to commodities and hedge funds.[12] The fact that PPNs allow "easy" exposure to 'alternative' asset classes can be part of the marketing.

The maturity is typically in 3 to 10 years[10] but can reach 15 years.[12] The principal protection is in nominal terms (before inflation). In real terms (after inflation), getting only the initial amount back after 10 years means a serious loss of purchasing power.

How they work

The issuing bank will typically purchase something like a zero-coupon bond to provide the maturity guarantee.[13] With the remaining funds, the issuer will typically purchase something like a call option to get (partial) exposure to the underling asset.[13]

Return calculation example

Return calculations of PPNs can be quite complex, but a relatively simple example is the Desjardins Canadian Financial Groups Principal Protected Notes, Series 232, with an issue date of May 29, 2025 and a maturity in seven years.[14] Even though this is a simple case, the information statement is still 32 pages long. This note provides equal weighted exposure to 5 Canadian Banks and 3 Canadian insurance companies. At the end of seven years, final stock prices will be compared to initial ones to calculate the 8 "reference asset returns", from which the "reference portfolio return" will be computed. A participation rate of 135% will be applied. The result will be the "variable return" of the note. At maturity, the investor will obtain the principal amount plus the variable return.

What's the catch? Dividends are not considered in those calculations, even though "the dividend yield of the Reference Portfolio at March 31, 2025 was 4.12%". Suppose that the annualized total return of the underlying stocks, including dividends, is 8.00% over the next 7 years. Taking out the dividends leaves 3.88% in price appreciation. Multiply by 135% and the PPN investor is left with 5.24% annualized return. This compares with an annualized return of 5.26% obtained in scenario 1 of the information statement. In scenario 2, the price return of the stocks ("reference portfolio return") is negative, so the investor gets no variable return.

Fees

Possible fees on PPNs include sales commissions, early redemption fees, as well as "management fees, performance fees, structuring fees, operating fees, trailer fees, and swap arrangement fees".[10]

According to the Canadian Securities Administrators (CSA), "these fees can significantly reduce the returns that would otherwise be derived from the underlying investments".[15]

Protection events

A feature of those products is that if the net asset value decreases to a certain point, a "protection event" or "knockout event" might occur. The note becomes "monetized", meaning that it "no longer carr(ies) any exposure to other underlying investments".[12] This means that even if the underlying assets were to recover, the total return of the PPN will stay at 0%.[16]

As a result of the great financial crisis, "by the end of December 2008, 169 PPNs were monetized across 12 financial institutions in Canada".[17] This lead CIRO (then IIROC) to perform a compliance review in 2009. The findings were that "Most of the Dealer marketing material was not adequate on its own as some key information was absent, such as information about the possible protection events (monetization events). Much of the marketing material examined also did not contain adequate information regarding charges and fees."[12]

Liquidity

Structured notes (other than exchange-traded notes) are not listed on an exchange.[18] So another characteristic of PPNs is their limited liquidity. Morningstar writes that "while it's easy to buy them, selling them before maturity is a different matter altogether".[19] There might be a secondary market for some PPNs, but issuers do not guarantee what value the investor might get if trying to sell before maturity (and there might be redemption fees as well).[16]

Quoting from the information statement and oral disclosure document for the Desjardins note mentioned above:[14]

The Notes will not be listed on any stock exchange. Desjardins Securities Inc. (“DSI”) intends to maintain until the Valuation Date, under normal market conditions, a daily secondary market for the Notes. DSI is under no obligation to facilitate or arrange a secondary market, and DSI in its sole discretion, may stop maintaining a market for the Notes at any time, without any prior notice to you. There can be no assurance that a secondary market will be available or that such market will be liquid or sustainable. (...) The notes may sell at a substantial discount on the secondary market.

In short, PPN investors must be willing to hold to maturity.

Taxes

The returns to PPNs is classified as interest and taxable as regular income.[5] This means that PPNs are not tax-efficient in non-registered accounts, compared to directly holding the underlying assets which tend to supply dividends or capital appreciation (instead of interest).

Have your cake and eat it too?

The marketing of PPNs can be quite aggressive, potentially implying that investors will get something like the safety of bonds and the upside of stocks or other risky assets. One major Canadian issuer is literally saying that "PPN investors can have their cake and eat it, too".[20] PPNs are often sold to investors nearing or in retirement, especially those who may not "possess the complex mathematics, statistics, and computer skills necessary to evaluate structured products, even though they may have years of investing experience".[21]

One industry veteran thinks that you can't actually have your cake and eat it too:[22]

I think PPNs are a bad compromise. They serve neither equity nor income-oriented investors very well. Equity investors buy stocks to generate higher long-term returns on their portfolio. Higher returns come from taking more risk and being subject to some short-term volatility. If you take the risk out of the product (that is, principal-protection), it follows that you will also take out the excess return. Fixed income investors, on the other hand, buy bonds for the certainty they provide. PPNs provide no such certainty. PPNs are like the elephant in the room. Everyone in the investment industry knows these products are not good for the client, but they're keeping quiet about it. Why? Because PPNs are big sellers and generate terrific profit margins. Financial executives may ignore the elephant, but investors would be advised to give it a wide berth.

Principal at risk notes

CIRO defines a principal at risk (PAR) note as a "financial instrument where the return is linked to the performance of a specified underlying security or underlying basket of securities and the investor carries a risk of losing part or all of the initial amount invested".[1] PAR notes are also known as "non-principal protected notes". Like for PPNs, PAR notes are debt obligations of the issuing bank or credit union; their returns are calculated based on formulas defined in the offering documents (with a link to underlying assets); there is no CDIC coverage; and liquidity is limited.

Because the principal of PAR notes is at least partly at risk, the marketing emphasizes other aspects, such as greater income (relative to the underlying asset or to conventional bonds/GICs), potentially high returns, or exposure to assets that are difficult to access directly (e.g., [23][24]).

Yield enhancement

Barrier reverse convertible

One type of structured product featuring yield enhancement, available in Europe[13] (and the US[18][25]), for which "under the hood" details are available, is called the "(barrier) reverse convertible". To understand what this means, we start with a convertible bond. Such a bond gives its holder the right to convert their debt securities into common shares of the same company, which they would typically want to do if the share price goes up. In exchange for this opportunity, the convertible bond will pay lower interest rates than regular coupon bonds.

Reverse convertible notes, in contrast, promise to pay coupons above the prevailing rates for conventional fixed income products. But "conversion" to equity only "happens" if the share price goes down, instead of up, and is not at the discretion of the note holder. In reality there is likely to be no actual conversion to equity, but the returns to the note holders are calculated by the issuer to be equivalent to that.

More specifically, the high coupons of reverse convertible barrier notes are achieved by capping the upside of the note to the coupons alone, and exposing the investor to downside risk of a reference asset below a barrier, such as 70% of the original index level (for example, the index could be the S&P500). The issuer might employ an exotic option called a "down and in put" (or barrier option), to create the downside risk exposure for the investor; the issuer will then hedge their own exposure to the barrier option using other derivatives (such as a put spread and S&P500 futures).[13]

If at maturity, the index is above the barrier, the investor will get their principal back (but no more, even if the underlying index had positive returns). If the index is below the barrier at maturity, the investor will get less than the principal back.

In the specific example provided by Paixao (2012), the yield that could have been provided to the investor assuming no issuer profit is about 9.5%, of which 2% is interest on the principal invested in money markets by the issuer, and 7.5% is from the option premium.[13] The issuer will actually offer a lower yield to the investor, contributing to the issuer profit. To assess how much of the yield the issuer is keeping (the "margin"), the investor would have to have knowledge of:[13]

  • Black-Scholes partial differential equations
  • Plain vanilla and exotic options, futures contracts, and option strategies such as put spreads
  • Dynamic hedging

The investor would also have to have access to institutional pricing for the various derivatives involved. In short, it is unlikely that the average buyer of a reverse convertible PAR note can calculate what the issuer margin is on the product -- or properly evaluate the risk -- due to the high level of complexity.

Auto-callable notes

A product available in Canada, somewhat similar to the barrier reverse convertible just described, is an auto-callable PAR note with a maturity-monitored barrier. Again there is a high yield and a possibility of losses below a barrier. One added twist is that if the index value has risen above a certain level at certain pre-determined dates, the note will automatically be called. As of May 2025, for example, one issuer offers notes with links to Canadian stocks, US stocks, Canadian banks, gold miners, and even single individual stocks, with 7 year terms.[26] One of these notes has been described on the Financial Wisdom Forum.[27]

Growth

Other types of PAR notes are designed to magnify the (hoped-for) positive performance of the underlying asset. Their names might include words such as "boosted", "accelerated", etc.

Alternatives

Index-linked GICs and PPN

The main selling feature of Index-linked GICs and PPN is the principal protection. But over a long enough period (decades), equities or balanced portfolios (mixes of equities and fixed-income, like bonds and regular GICs) are very unlikely to have negative nominal returns (see Canadian asset class returns 1900 - 2000). The capital protection of index-linked GICs and principal protected notes is therefore costly and not necessary over a long enough time frame. Instead, investors could simply buy fixed-income products (e.g., normal GICs, bond ladders, bond index funds, bond ETFs ...) and equities (e.g., index funds or index ETFs) in proportion to their chosen asset allocation. See Portfolio design and construction.

PAR notes

Retired investors being offered yield enhancement products should ask themselves how the structured note is generating so much income, what risk(s) that strategy might involve, and what margin of profit the issuer is keeping. The alternative is again a diversified portfolio of stocks and bonds, and the "natural" income (dividends and interest) can be supplemented by small asset sales if required, keeping in mind an overall suitable withdrawal rate from the portfolio, guided by the chosen withdrawal strategy. If the investor can live with the potential downside of equities, he or she should enjoy the potential upside as well.

References

  1. ^ a b c Canadian Investment Regulatory Organization, Amendments regarding margin requirements for structured products, February 22, 2024, viewed April 28, 2025 (see appendix B).
  2. ^ RBC Capital Markets, structured notes, Existing Products, viewed April 28, 2025.
  3. ^ CIBC Capital Markets, Structured notes, Previously issued, viewed April 28, 2025.
  4. ^ Swedroe L (2023) Structured Notes Are Financial Fairy Tales, August 25, 2023, viewed May 3, 2025
  5. ^ a b c Li Y, Anderson S, McGraw PA (2022) Do the Underlying Portfolios Matter? A Comparative Study of Equity-Linked Pay-at-Maturity Principal Protected Notes in Canada and the UK. Journal of Risk and Financial Management 15:462, DOI 10.3390/jrfm15100462, viewed April 30, 2025.
  6. ^ Benjamin Felix, Structured notes are designed to exploit cognitive and emotional investor biases, Globe and Mail(subscription required), updated September 30, 2024, viewed May 3, 2025.
  7. ^ Henderson BJ, Pearson ND (2011) The dark side of financial innovation: A case study of the pricing of a retail financial product. Journal of Financial Economics 100:227-247, DOI 10.1016/j.jfineco.2010.12.006, viewed May 3, 2025. See also Das SR, Statman M (2013) Options and structured products in behavioral portfolios, Journal of Economic Dynamics and Control 37:137-153, PDF available from the author
  8. ^ Andrew Hepburn, Why You Should Avoid Equity-Linked GICs, Canadian MoneySaver, May 5, 2016, viewed June 1, 2023.
  9. ^ Mezzetta R (2008) Market-linked GIC products for risk-averse clients, Investment Executive, January 21, 2008, viewed July 1, 2023.
  10. ^ a b c Ontario Securities Commission, Principal protected notes (PPNs), updated September 26, 2023, viewed April 25, 2025.
  11. ^ Dimon Kaplan & Rothschild (a US law firm), The Myth of “100% Protected” Securities, January 28, 2023, viewed April 29, 2025.
  12. ^ a b c d Canadian Investment Regulatory Organization (CIRO), Principal Protected Notes Compliance Review, Guidance Note GN-3900-21-003, December 31, 2021, viewed April 25, 2025.
  13. ^ a b c d e f Paixao TACN (2012) Guide to Structured Products – Reverse Convertible on S&P500, Universidade NOVA de Lisboa (Portugal), viewed May 4, 2025.
  14. ^ a b Desjardins Canadian Financial Groups Principal Protected Notes, Series 232, Client summary, Information statement (April 24, 2025), Oral disclosure document, viewed April 29, 2025.
  15. ^ Canadian Securities Administrators (CSA), https://www.osc.ca/en/securities-law/instruments-rules-policies/4/46-303/csa-notice-46-303-principal-protected-notes, July 7, 2006, viewed April 30, 2025.
  16. ^ a b Investment Executive, “Down” markets hammer the performance of PPNs, December 2, 2008, viewed April 27, 2025.
  17. ^ Salzer S (2018) Hitting a bum note: PPNs promise investing nirvana, but the reality can be quite different, viewed April 30, 2025.
  18. ^ a b US Securities and Exchange Commission (SEC), Investor Bulletin: Structured Notes, January 12, 2015, viewed May 8, 2025.
  19. ^ Morningstar, Principal-protected notes do have downside -- They may end up being a zero-interest loan to the issuer, October 14, 2016, viewed April 25, 2025.
  20. ^ Perfect timing for Principal Protected Notes (PPNs)?, May 15, 2023, viewed April 27, 2025.
  21. ^ Olazábal AM, Marmorstein H (2010) Structured Products for the Retail Market: Regulatory Implications of Investor Innumeracy & Consumer Information Processing. Arizona Law Review 52:623, also available at SSRN, viewed April 26, 2025.
  22. ^ Tom Bradley, Principal-protected Notes Give Investors Worst of Both Worlds, blog, August 3, 2006, viewed April 27, 2025.
  23. ^ CIBC Investor's Edge, Understanding structured notes: Principal At Risk Notes, February 18, 2022, viewed May 4, 2025.
  24. ^ Scotiabank, Types of structured notes, undated, viewed May 4, 2025.
  25. ^ US Financial Industry Regulatory Authority (FINRA), Reverse Convertibles: Complex Investments, July 7, 2023, viewed May 8, 2025.
  26. ^ National Bank Structured Solutions Group, PAR notes, Current issues, Income/ROC
  27. ^ Financial Wisdom Forum, Description of "NBC Auto Callable Contingent Income Note Securities (Maturity-Monitored Barrier) linked to the Solactive Berkshire Hathaway Hedged to CAD Index 3% Decrement, Class F, due on May 17, 2032", written May 2, 2025.

Further reading

External links

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