Structured Products

CHAPTER 23: Structured Products

CSI Global Education Inc.

Structured Products
• Passive investment vehicle financially engineered to provide
specific risk/return profile.
• The value of the products is derived from underlying securities.
• Wide range of underlying assets: Single or basket of securities,
indices, currencies, commodities, loans, etc.
• Issuers provide access to assets unavailable to retail investors
• Usually have fixed termination date
• Create liquidity for issuers via securitization process
• Types: mortgage-backed security, principal protected note
(PPN), market linked GICs, etc.

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Structured Products
Advantages
• Professional management, diversification, economies of scale
• Higher yield vs. conventional fixed income products
• High probability of return of principal upon maturity
• Disadvantages:
Disadvantages
• Complexity & financial engineering risk
• Potentially high fees (especially with principal protected notes)
• Illiquidity of secondary market

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Risk Associated with Structured Products

Credit risk – default of bonds and other fixed income securities..

Inflation Risk – Loss of purchasing power.
Currency Risk – foreign currency investments
Prepayment Risk – earlier prepayment of mortgages; lower return.
Manager Risk – improper management skills

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Principal Protected Notes (PPN)
• Deposit notes issued mainly by Schedule I and II Banks
• Principal guaranteed if held to maturity
• Return based on performance of underlying asset (Baskets of
stocks, indices, commodities, mutual funds, etc.)
• May use leverage to enhance returns
• Suitable for conservative investors requiring principal guarantee
who also want exposure to riskier asset classes
• Fees tend to be higher than investing directly in underlying assets
• Main types are: Index Linked, Mutual or Hedge Fund Linked
• Light regulation – not treated as a security or fund

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PPN Related Entities
Guarantor or Issuer
• Bank or government entity that guarantees principal of note
Manufacturer
• Design, structure and market notes
• Mostly big 6 banks and a few independent firms
Distributor
• Investment and Mutual Fund Dealers employing advisors
• May be independent firm or bank owned brokerage firm

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PPN Risks & Tax Liability
• Principal protected if held until maturity
• Performance risk: PPNs face the volatility of underlying asset
when trading above issue price (market, currency, manager
risks, etc.)
• Liquidity risk: liquidity may be an issue (if no secondary market
exists)
• Credit risk associated with issuing entity –issuer may be unable
to return principal at maturity.
• Call risk : The issuer may redeem the PPN before maturity
• Income is taxed as interest income if PPN is held until maturity
• Income may be considered a capital gain if sold before maturity –
but CRA has not issued a formal “opinion” supporting this fact

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Market -Linked Guaranteed Investment
Certificates (GIC)
• Offer principal guarantee similar to PPN
• Return is based on performance of underlying equity index
• Simple comparison between opening and ending level of index
• May face capped return (e.g., 100% over 5 yrs.) or participation
rate
• No liquidity or chance to sell GIC before maturity
• All income taxed as interest income
• Risk/reward profile similar to an option-based PPN, limited by
capped returns and/or participation rate and facing lower fees

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 Index-Linked GIC Return Example
Initial Index Ending Index Index Growth Participation Overall
Level Level over the Period Rate (Maximum Return
Cap)

9,000 12,000 33.33% 30% 10%

A participation rate of 30% means that you will get only 30% of the
Market index growth.
Index Growth = (Ending Index Level – Initial Index Level) / Initial Index
Level x 100

Overall Return = Index Growth x Participation Rate

CSI Global Education Inc. Source: CSC Textbook 9

Split Shares
• First popular exchange-traded structured product
• Structuring splits risk/return characteristics of underlying portfolio
of common shares
• Structure is like 2 investors teaming up to buy a single stock
• Preferred shares receive majority of dividends
• Capital shares receive majority of capital gains
• Shares issued for specific period of time (3 – 10 years)
• Taxed similarly to mutual fund trusts or corporations

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Split Share Risks and Returns
Preferred Share
Receives majority of dividends
Little chance for capital gain
Paid first in case of insolvency
Trade like a preferred share or
bond
Face dividend cut risk,
reinvestment risk, credit risk, early
redemption risk and early closing
risk
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Capital Share
May receive residual dividends
Participates fully in capital gains
Paid last in case of insolvency
Trade like a common share
Face capital market risk (higher
volatility), and dividend cut risk
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Asset-Backed Securities (ABS)
• Securitization converts financial assets (mortgages & loans) into
marketable securities
• Shifts credit risk from issuer of debt to investor in security
• Reduces capital requirements of originators and creates liquidity
for borrowers
• Originators use Special Purpose Vehicles (SPV) to move assets
off their balance sheets
• Issuers finance purchase of assets by SPV and sell the ABS to
investors
• Originator and issuer both collect fees to create the ABS

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Securitization Process

CSI Global Education Inc. Source: CSC Textbook 13

Asset-Backed Commercial Paper (ABCP)
• Short-term ABS – typically 90 – 180 days
• Competes in money markets against T-Bills and Commercial
Paper issued directly by corporations
• Offers higher yields due to potentially riskier underlying assets
(Residential & commercial mortgages, car loans, credit cards &
lines of credit, etc.)
• In Canada in 2007, U.S. sub-prime mortgage-backed ABCP
liquidity crunch hit when investor appetite disappeared
• ABCP originators and government intervened in market to
protect investors – settlement reached by 2009

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Mortgage-Backed Security (MBS)
• ABS based on pool of residential & commercial mortgages
• Provide access to huge pool of capital for mortgage originators
• Known as pass-through securities as all income is passed
through to the investors
• National Housing Act (NHA) MBS are guaranteed by Canada
Mortgage and Housing Corporation (CHMC)
• Typical term of 3-10 years
• Yield is usually higher than government debt of similar term, but
risk is similar if underlying mortgages are CMHC insured

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MBS Advantages & Disadvantages
Advantages
• Implicit government guarantee (NHA MBS)
• Higher yields than government bonds of same term
• Offer indirect exposure to real estate market
• Monthly interest payments and registered plan eligibility
Disadvantages
• Credit, interest rate and market risk create volatility in both
interest payments and principal amount (if sold before maturity)
• Prepayment risk evident when interest rates are high

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