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As investors seek investments that produce strong income in today’s climate of historically low interest rates and yields, where should they turn? Advisors who are working out income allocations for their clients’ portfolios should give structured products a closer look, says Benoit Belanger, director, guaranteed products development and financial modelling at Desjardins Group.
Generating higher yields than fixed income, structured products, including notes, often provide another benefit: protection during bear markets. Despite these advantages, structured notes are underused and overlooked among most investors.
“Even a lot of advisors don’t use these [products] because they’re unfamiliar with them,” Mr. Belanger says. “That’s because they’re still niche products, even though the market value of all structured products in Canada is around $97-billion[1].”
Structured products represent a mere sliver of assets under management in Canada, especially when you take market-linked guaranteed investments out of the picture. Yet, these notes have plenty of room to grow with retail investors.
For one, they can offer a consistent conditional or guaranteed coupon, similar to bonds, only their underlying assets don’t just consist of debt instruments.
Many structured notes also use derivatives to provide market exposure, which creates a blend of qualities unlike any other investment. In turn, that helps diversify portfolios further, Mr. Belanger affirms.
Consider a situation in which an advisor is building an income-focused portfolio for a high-net-worth client. Some structured notes could generate coupons “as much as three times what you would receive from standard fixed income,” he says.
Above PAR performance
With terms to maturity of three to eight years, structured products can vary in their risk/return profile. They generally fall into two broad groups: principal-protected notes (PPNs) and principal-at-risk (PAR) notes.
In the current climate, PAR notes have been more attractive, offering potentially higher returns and some level of protection against equity risk, Mr. Belanger says.
To accomplish their mandates, most PAR notes hold underlying exposure to equity markets. That helps them generate returns to drive higher yields for income investors. Other PAR products are more growth-oriented, with returns paid at maturity for client portfolios.
Either way, these notes frequently have risk-protection overlays to secure income streams, principal, or both.
Yet, as the name suggests, this protection has limits.
For example, a structured note may offer coupon protection as long as the principal doesn’t drop by more than 30 per cent because of a steep equity market downturn, Mr. Belanger explains.
However, once the underlying value rises above that low watermark, the coupon payment restarts.
Using the same example, the note’s principal is reduced only if its value remains below that threshold at maturity.
“So, if you are only at negative 28 per cent at maturity, you will still get all your capital back,” Mr. Belanger says. “That’s why notes with this protection are so popular right now.”
Another potential benefit is that structured products can be traded on a secondary market. Yet, only the issuer can buy back the product at a certain price, with these assets priced daily.
Most people hold structured notes until maturity. These investments provide higher potential yields than fixed income without adding much risk. Along with that, structured notes offer less equity market risk than preferred shares and other income-producing equities, Mr. Belanger explains.
“Another advantage is that notes aren’t dependent on what happens with interest rates as long as they are owned until maturity,” he says.
Markets have diversified
In the past decade, the structured notes market has shifted more toward PAR notes. More broadly, the market has grown diverse, with products becoming increasingly complex as providers add new bells and whistles.
“At Desjardins, we have a different philosophy in that we aim to offer simpler, more transparent products that fit with investors’ needs today,” Mr. Belanger says.
He adds that advisors play a critical role in helping clients find the right product. Desjardins is often a first choice because its best-in-class lineup of structured products has won multiple awards for 10 years running, including the 2021 SRP Best House, Canada Award for a second year in a row.
Regardless of the provider or client need, structured products warrant attention.
“In any client portfolio, there’s room for structured products because of the many benefits they provide,” Mr. Belanger says.
[1]As at December 31, 2020. Investor Economics, Household Balance Sheet Report – Canada, 2021
An investment in principal protected notes (PPNs) may not be suitable for all investors. Important information about principal protected notes is contained in the Information Statement and the Oral Disclosure Document of each note. Investors are strongly encouraged to carefully read this documentation related to a note issuance before investing and to discuss the suitability of an investment in the notes with their investment advisor or dealer representative before making a decision. The documentation related to a notes issuance in particular is available on the summary page of that issuance. In the event of any inconsistencies or conflicts between this document and the Information Statement, the Information Statement governs. The offering and sale of notes may be prohibited or restricted by laws in certain jurisdictions in Canada and notes are not offered for sale outside Canada. Notes may only be purchased in the jurisdictions where they may be lawfully offered for sale and only through individuals duly registered and authorized to sell them. Past performance is not indicative of future performance. The return on principal protected notes is dependent on the change (which may be positive or negative) in value of the underlying assets during the term of the note and it is possible that there may be no interest payable to the investor. The return on a note cannot be established before maturity. Some notes may be subject to caps, participation rates and other limits which feed through to performance. The full principal amount of a principal protected note will be repaid at maturity only. An investment in notes is subject to certain risk factors. Please read the Information Statement and Oral Disclosure Document for complete details, including the precise formula for determining return on a note.
The PPNs and NPPNs (collectively, the Notes) will not constitute deposits that are insured under the Deposit Institutions and Deposit Protection Act (Québec), the Canada Deposit Insurance Corporation Act or under any other deposit insurance regime.
Advertising feature produced by Globe Content Studio with Desjardins. The Globe’s editorial department was not involved.