A Primer on Structured Notes
With the return of equity market volatility and the high concentration among a handful of mega-cap names, alongside volatile bond markets as central banks have raised and lowered interest rates, there has been significant interest in structured notes. For those investors looking beyond traditional investment models, structured notes may be suitable additions to a diversified portfolio. They can offer a range of benefits: some notes allow conservative investors the opportunity to earn potential profits from volatile sectors without risking capital; other notes provide growth-focused investors the potential to achieve above-average returns compared to traditional investments.
Structured notes are customized investments whose performance is based on a reference asset, market measure or investment strategy. Typically, structured notes combine an equity option/derivative, providing an investor upside exposure
to an asset class, and a debt instrument (usually a bond) to simultaneously provide some downside protection. Structured notes commonly pay a coupon, with the frequency varying based on the type of structured note. Most notes pay a single, conditional coupon at maturity, while others may pay regular, fixed or floating coupons at specific intervals.
Structured notes are akin to an ‘IOU,’ where the issuer promises to pay a certain amount of money at a specified time. However, the future interest income isn’t predetermined when the note is issued; it is linked to the future performance of an externa l benchmark.
The opportunity with these notes varies. With more conservative notes, the investment may be shielded from a large decline, but any future gains will still provide returns to the investor. With more aggressive structured notes, the upside potential may be very attractive and outperform the market, but the downside protection may be limited.
Of course, no investment is without its risks, so it’s important to consider the following when investing in structured notes:
Downside risk — Some notes do not have principal protection, meaning that the entire principal outlay is at risk. Other products may have only conditional protection of principal.
Tax treatment — Generally, structured notes are taxed as interest income, so any gains would be taxed at ordinary income rates, not capital gains rates.* For many investors, this potential disadvantage can be overcome by including this type of investment in a registered account.
Ability to be called — Many structured notes are callable, meaning the issuer can force an investor to redeem the note before maturity. This may be done by an issuer to prevent the return from becoming too high.
Holding period — In many cases, it is expected that the investor will hold the investment until maturity. Structured notes are not listed on any exchange and the secondary market for structured notes is limited. Therefore, if the investor wishes to sell the structured note prior to maturity, there may be associated losses.
Today, the growing number of structured notes available in the marketplace gives investors more choice, but there are also varying degrees of quality with these products. As such, it is important to be aware of the terms associated with any particular structured note. As always, the inclusion of any investment into an investment portfolio, including structured notes, should be aligned with the investor’s particular risk tolerance and personal investment plan.
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If you are interested in learning more about the different types of structured notes that may be appropriate additions to your portfolio, please call for a deeper discussion.
*There may be differing tax treatment if notes are sold at a profit prior to maturity, with gains treated as capital gains. Some notes are also structured so that the distributions are considered “return of capital.”
The taxation of these instruments can be very complex and are very nuanced. Ensure to consult your qualified tax professional to understand the tax implications of your specific structured note.
The information contained herein has been provided for information purposes only. Graphs, charts and other numbers are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information has been provided by J. Hirasawa & Associates and is drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. This does not constitute a recommendation or solicitation to buy or sell securities of any kind. Market conditions may change which may impact the information contained in this document. Wellington-Altus Private Wealth Inc. (WAPW) and the authors do not guarantee the accuracy or completeness of the information contained herein, nor does WAPW, nor the authors, assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Before acting on any of the above, please contact me for individual financial advice based on your personal circumstances.
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