Chapter 23
Structured Products
Overview of Structured Products
Definition A structured product is a passive investment vehicle financially
engineered to provide specific risk and return characteristics. Its
value tracks the returns of an underlying asset.
Purpose They offer investors risk, return, tax, and diversification
characteristics not available from conventional investments. They can
be designed for enhanced yield, capital protection, and tax efficiency.
Underlying Can reference a single security, a basket of securities, an index,
Assets commodities, foreign currencies, or a combination. Examples include
mortgage loans, credit card receivables, car loans, equity indexes, and
home equity loans.
Design Structured products are designed to have less risk than their underlying
assets while providing higher risk-adjusted returns than conventional
investments.
Issuers Typically established financial institutions like banks or consumer finance
firms, leveraging economies of scale and market reach.
Regulation Not currently subject to National Instrument 81-102 (which governs
mutual funds), allowing them to use strategies like leverage or derivatives
to improve returns.
Types of Structured Products
The sources detail several types of structured products:
1. Principal-Protected Notes (PPNs): Bank-issued debt securities with returns linked to an
equity index, mutual fund, exchange-traded fund (ETF), or basket of stocks. They involve
derivatives and fixed income.
2. Market-Linked Guaranteed Investment Certificates (GICs): Bank-issued debt securities
with returns linked to an equity index, mutual fund, ETF, or basket of stocks. They also
involve derivatives and fixed income.
3. Split Shares: Equity securities with separate claims on dividend and capital cash flow from a
holding of underlying dividend-paying stocks.
4. Mortgage-Backed Securities (MBSs): Medium- to long-term bonds with equal claim on
principal and interest cash flows from a pool of residential or commercial mortgages.
5. Asset-Backed Securities (ABSs): Short- to medium-term bonds with equal claim on
principal and interest cash flows from a pool of receivables like consumer loans (home
equity, student, auto, and credit card).
Advantages of Structured Products
• Professional Management: Benefit from expert oversight.
• Economies of Scale: Issuers can assemble underlying assets that individuals couldn't
afford.
• Diversification: Combine high-risk, illiquid securities into lower-risk, higher-yield
instruments.
• Capital Protection: High likelihood (though not certain) that the entire principal will be
returned at the end of the investment period.
Disadvantages and Risks of Structured Products
• Complexity: Difficult for many investors to assess inherent risks, especially those using
significant derivatives.
• Illiquidity: Often have a thin or non-existent secondary market. Issuers may provide a
secondary market on a best-efforts basis, but with wide bid/ask spreads or no support in
volatile markets.
• High Cost Structure: Include various fees such as selling commissions, management
fees, performance fees, structuring fees, trailer fees, and swap arrangement fees, requiring
a significant hurdle before reasonable returns are made.
• General Investment Risks: Exposed to default risk, inflation and interest rate risk,
currency risk, and manager risk.
• Prepayment Risk: Specific to investments like MBSs, where underlying mortgages
might be paid off earlier than expected, shortening the investment's life and potentially
leading to lower returns.
Principal-Protected Notes (PPNs)
Features • Debt instrument issued by a bank in the form of a deposit note.
• Guarantees return of principal at maturity.
• Interest payment is not guaranteed; it's tied to the performance of
an underlying asset (portfolio of stocks, index, mutual funds, ETFs).
• Not considered securities and are not issued under a prospectus;
issuers provide information statements.
• Not insured by the Canada Deposit Insurance Corporation
(CDIC), despite being issued by banks.
• Typical term to maturity ranges from three to eight years.
Role of Issuers • Guarantor: Guarantee principal return based on their
(Big Six Canadian creditworthiness.
Banks) • Manufacturer: Choose underlying assets, term, and special
features for interest payments.
• Distributor: Primarily through their investment dealer arm.
Structure • Uses a zero-coupon bond plus option structure.
• Most proceeds are invested in a zero-coupon bond (same maturity
as PPN) to guarantee principal return.
• The remainder is invested in an option on the underlying asset to
fund potential interest payments.
Types of PPNs • Index-Linked PPNs: Linked to an underlying index (e.g.,
S&P/TSX 60 Index). Exposure is limited by:
o Participation Rate: Final payoff is a percentage of the
index return.
o Performance Cap: Final payoff equals 100% of the index
return, but is limited to a predetermined maximum.
o Note: Returns are typically based on price-return versions
of the index, excluding dividends.
• Stock Basket-Linked PPNs: Linked to the average return on a
basket of common shares (typically 10-15).
o Return is the average return of individual shares, often
capped per share, which caps the overall PPN return.
o Some may offer a small guaranteed minimum return above
principal.
o Typically exclude dividends from calculation.
Risks Associated • Liquidity Risk: While some offer early redemption, the buy-back
with PPNs (despite price may include embedded fees, and issuers are not obligated to
principal guarantee) support a secondary market. Investors should be prepared to hold
until maturity.
• Performance Risk: PPN returns may be lower than the underlying
asset due to the cost of principal protection.
• Credit Risk: Guaranteed by banks but not CDIC-insured. Investors
should consider the issuer's creditworthiness.
• Currency Risk: If tracking foreign currency-denominated assets,
investors are exposed to currency risk unless specified otherwise.
Important • Not appropriate for investors needing a predictable stream of
Considerations income (income is usually not guaranteed and often below market
yield).
• Not appropriate for investors needing liquidity (liquidity is not
guaranteed).
• Investors with average or above-average risk profiles and long time
horizons should consider diversified portfolios as an alternative.
Tax Treatment • Any return (from holding to maturity or sale) is generally taxed as
interest income.
Market-Linked Guaranteed Investment Certificates (GICs)
Features
• Fixed-income security offering fixed or variable interest rates for a specific term.
• Issuer guarantees both principal and interest payments, and the investment is insured by the
CDIC.
• Customized product linking returns to an underlying asset (stock index, mutual fund,
ETF).
• Popular for conservative investors seeking guaranteed security with equity market exposure.
• Typically offered with three- and five-year terms and are usually non-redeemable until
maturity.
• The principal is guaranteed, but total return is not known until maturity.
• May be limited by a maximum cap on returns or a participation rate.
• If the underlying asset falls in value, only the original principal is returned, generating no
return.
Calculating Returns
• Uses initial/ending index levels, index growth, and performance cap/participation rate. Some
GICs average returns over periods or allow lock-ins/early redemptions at specific dates.
Risks
• Main risk: Underlying index or fund remains stagnant or falls, resulting in no return
beyond principal.
• Secondary risk: Non-redeemable prior to maturity, requiring investors to hold to term.
Tax Implications
• Returns are classified as interest income. If purchased outside a registered plan (e.g., RRSP),
gains are added to income and taxed at the investor's marginal rate in the year of maturity.
May be more tax-efficient in registered plans.
Split Shares
Structure
• A security that divides the investment attributes of an underlying portfolio of common
shares into separate components.
• Created by split share corporations (a type of closed-end fund) that hold common shares
and issue two types of shares: preferred shares and capital shares.
• Issued for a specific term (3-10+ years), after which the company redeems the shares.
Preferred Shares
• Receive the majority of dividends from the underlying common shares.
• Appeal to equity investors willing to sacrifice capital gain for dividend income.
• Have a priority claim on all available dividends and a priority claim on the capital of the
portfolio up to a certain value.
Capital Shares
• Receive the majority of any capital gains on the common shares.
• Appeal to equity investors willing to sacrifice dividend income for capital gains.
• Receive all capital appreciation above what the preferred share is entitled to. May also
receive dividends after preferred shares are paid.
• Provide a leveraged investment in the underlying common shares.
Risks Associated with Split Shares
Both types are influenced by the financial health of the underlying portfolio and management
quality.
Capital Share Risks
Hold much more risk than preferred shares.
• Ranked after preferred shares in priority during wind-up.
• Not paid until after obligations to preferred holders and other liabilities are paid.
• Inherent Leverage: Can lose entire investment if the underlying portfolio declines
sufficiently.
• Volatility: Significantly more volatile than underlying common shares.
• Dividend Cuts: Susceptible to dividend cuts, especially if preferred shares have a guaranteed
dividend (leading to sales of portfolio shares).
Preferred Share Risks
Despite priority, they face uncertainty.
• Reinvestment Risk: If shares are redeemed early (e.g., if asset value falls below a level),
investors may need to find new investments with lower yields or fewer tax advantages.
• Early Redemption: Investors may lose any premium paid if shares are redeemed early.
• Credit Risk: Risk of change in the issuer's creditworthiness, which can lower preferred share
price.
• Decline in Value of Underlying Portfolio: A significant decline can reduce preferred share
price, though they have some protection from the capital share's value.
• Taxation Risk: Changes in government tax status (e.g., flow-through entities) or general tax
rates could alter their appeal.
• Dividend Cuts: If underlying dividends are cut, preferred share value is reduced, especially
if the split-share dividend is tied to the portfolio dividend.
Tax Implications
• Split-share corporations pay out all net profits to shareholders without paying income tax
themselves; income is taxed in the shareholder's hands.
• Capital shareholders may still receive dividends from profits not owed to preferred holders
(e.g., from portfolio sales or rising dividends) and must declare and pay tax on this income.
• The lower tax rate on preferred share dividend income is an attractive feature, but its appeal
depends on the investor's marginal tax bracket and province of residence.
Asset-Backed Securities (ABSs)
Asset Securitization Process:
• Aggregates financial assets (mortgages, loans, receivables) and transforms them into
marketable securities.
• Used by financial institutions to transfer credit risk from their balance sheets to institutional
investors, freeing up capital.
• Three-step process:
o Originator (company with income-producing assets) groups assets into a reference
portfolio.
o Originator sells the pooled assets to a Special Purpose Vehicle (SPV), set up solely
to purchase assets and remove them from the originator's balance sheet.
o The issuer finances the SPV's purchase by selling marketable securities (ABSs)
to investors (large financial institutions, pension plans, mutual funds, hedge funds).
• The originator usually services the assets for a fee, passing net interest income to the SPV,
which then redistributes it to ABS investors as fixed or floating-rate interest payments.
• Most ABS securities divide the reference portfolio into tranches, each with its own credit
risk and return level, sold separately.
• Tranche Hierarchy:
o Senior: Most creditworthy, first claim on income, least credit loss risk, largest.
o Mezzanine: Receives payments after senior tranche is fully paid.
o Junior: Least creditworthy, receives payments last, greatest credit risk, smallest,
expects higher returns for higher risk.
Asset-Backed Commercial Paper (ABCP):
• A type of ABS with a maturity date of less than one year (typically 90-180 days).
• Shares the same legal and design structure as standard ABS.
• Designed to minimize roll-over risk (risk that the issuer cannot refinance underlying assets
when ABCP matures) by matching short-lived assets with short-term funding.
• Repayment depends on cash flows from SPV assets and the issuer's ability to issue new
ABCP.
• Canadian ABCP Crisis (2007):
o Non-bank managed ABCP issuers could not renew outstanding ABCP due to
unfavorable market conditions.
o Many ABCP trusts held increasing shares of U.S. residential mortgage loans,
exposing them to the U.S. housing crisis.
o Investors became concerned about potential credit losses from subprime mortgage
exposure.
o Issuers extended maturity dates; most banks declined liquidity requests based on
market disruption clauses.
o Canadian Schedule I banks voluntarily honored redemptions to ensure market
stability, avoid panic, and protect their reputations.
o Key contributing factors to the crisis included a mismatch between ABCP and
underlying asset maturities, investment in risky assets/derivatives, and unclear legal
terms regarding liquidity guarantee clauses.
o A key lesson was the lack of transparency regarding underlying investments in
many ABCP products.
Mortgage-Backed Securities (MBSs):
• A class of income-producing structured product designed to provide liquidity in the illiquid
mortgage market.
• Also known as mortgage pass-through securities.
• A type of bond that claims ownership to a portion of cash flows from a pool of mortgages.
• An intermediary collects monthly payments, deducts a fee, and remits them to MBS holders.
• Similar to other bonds: Carry interest rate risk and credit risk; prices are inversely related to
interest rates.
• Unlike other bonds: Many have prepayment risk, where homeowners pay down principal
early, shortening the MBS life.
• Most MBSs are assumed to be of AAA credit quality due to explicit or implicit government
guarantee (e.g., through Canada Mortgage and Housing Corporation - CMHC in Canada).
Structure and Benefits:
• Backed by residential properties (single-family, multi-family, social housing).
• Fully insured by CMHC for interest, principal, and timely payment.
• Can be structured with open (prepayable) or closed (non-prepayable) pools of mortgages.
o Open NHA MBS: Underlying property owners can prepay principal, leading to
uncertain cash flows and yields.
o Closed NHA MBS: Social housing and multi-family mortgages; prepayment is not
allowed, leading to more certain cash flows.
• Income stream includes interest, scheduled principal payments, and sometimes
prepayments/penalties, less fees.
• Terms can be 3 to over 10 years.
• Primary Benefit: Monthly income stream, suitable for retirement.
• Only interest income is taxable; return of principal is not.
• Fully liquid and can be sold at market value.
• Allow investment in real estate without default risk or collection issues.
• Commonly five-year pools in multiples of $5,000.
• Earns returns comparable to or higher than GICs, and typically higher than T-bills or
Government of Canada bonds with similar terms due to a yield premium.
• Eligible for RRSPs, RRIFs, and TFSAs.
Risks
• Reinvestment risk with prepayable MBSs: If rates decline, new investments may not offer
the same attractive yield.
• Increased payments from unscheduled prepayments reduce future interest payments.
• Default or damage to a mortgage property can lead to early full principal payment and
cessation of interest payments from that property.
• Though liquid, a capital loss may be incurred if market rates increase and there is
considerable time to maturity when selling.