Structured notes: yea or nay?

Investing in structured notes (SN) varies by complexity and risk. They are certainly not for everyone. However, they are still a good investment product to consider adding to your portfolio for further diversification.

So, what are they?

SNs are unsecured debt obligations originating from financial institutions. Most are issued by Canadian Schedule 1 chartered banks, but they are nothing like a GIC and they are not covered by the CDIC insurance.

SNs can be thought of as an alternative to other investment products like exchange traded funds (ETF) or mutual funds (MF), however the benefit is that they will have a stated maturity date when they are to be cashed out.

Most come with a fixed payout date upon maturity, but you can also acquire SNs that pay a fixed or variable payment over the life of the product.

SNs have distinct tax advantages since you can make future withdrawals from the product as a return of capital (ROC) payment, which defers the tax until maturity or disposition of the note.

The two types of SNs to choose from are principal protected notes (PPN) or non-principal protected notes (NPPN). A PPN is the most common and has been used for years as an alternative to fixed income investments such as GICs. The principal is fully guaranteed by the bank at maturity and there is usually a variable coupon payment paid out on the investment.

NPPNs are very different. With a NPPN the principal investment in not guaranteed at maturity, however they are much more tax efficient than a traditional PPN.

There are basically two types of NPPNs: long-equity NPPNs and option-based NPPNs. For those starting out, I would advise choosing a long-equity NPPN, since this is regarded in the industry as a “one-ticket” solution whereby all decisions about the trades in the portfolio are done within the product and there are no additional transaction costs beyond the fees stated in the note.

An option-based NPPN is quite different. This product is highly customized and facilitated through option strategies based on the underlying asset or the yields in the bond market. These products are complicated for the average investor and can be further divided into buffered-NPPNs or accelerated-NPPNs.

If you plan to explore the possibility of adding SNs to your portfolio, be sure to understand their risks. I would highly recommend seeking the guidance of a qualified adviser who knows you well. They can ensure that if you choose SNs, they'll be consistent with your investment objectives, your portfolio's risk factors and your personal future liquidity needs.

Be sure to fully comprehend the amount of principal at risk (if any) and the method for calculating any redeemable coupon payments, as well as the amount to be paid out at maturity (less associated fees).

Remember, the best SNs are those that are simple and transparent. Also, don't just go on your adviser's recommendations. Make sure you read and understand the associated risks that will be outlined in the offering documents for each product.