Linked notes are investment products made up of two elements: a portion that guarantees the invested capital and a portion linked to market returns, providing a certain potential – and not a guarantee – for growth.
Calculating a linked note’s yield
Linked notes yield is only known at maturity. It is determined based on the note’s characteristics and the underlying asset performance on the market.
The different types of linked notes
Linked notes are designed according to two structures:
1 - Zero coupon bond and option strategy – As the name implies, this structure uses two components: a zero-coupon bond to guarantee the principal at maturity and an option strategy to generate a return.
Unlike a traditional bond, a zero-coupon bond pays no interest to the bearer during the investment period. As a result, it trades at a discount, i.e., a price below its face value. The two factors that have the greatest impact on the price of zero-coupon bonds are the time to maturity and interest rates. The higher the rate, the lower the price.
Investing in an option strategy allows you to take advantage of the index’s growth potential. Should the index go down, the option strategy will expire without value, but because of the zero-coupon bond, you will still receive your invested capital at maturity. However, if the index goes up, the option strategy will provide a gain on your initial investment so that at maturity, you would receive both your invested capital and the additional yield.
2 - Dynamic leverage policy – The dynamic leverage structure is not as common. It utilizes a simple formula to determine the amount to invest in the underlying asset.
Usually, 100% of the amount is invested directly in the underlying asset at the onset. The value of this investment is subsequently estimated regularly, and compared to the price of a notional zero-coupon bond with the same term to maturity as the note. The difference between the two is usually called the “spread.” As long as this spread remains positive, the investment in the underlying asset is maintained because there is still enough money to buy the guarantee, i.e., the zero-coupon bond. However, if the spread becomes nil, the investment in the underlying asset must be sold and the zero-coupon bond purchased.
The spread is influenced by changes in both the value of the underlying asset and interest rates. If interest rates rise, the price of a notional zero-coupon bond will fall, thereby widening the spread, and vice versa.
The benefits of linked notes
Linked notes are very useful for less-risky portions of the portfolio, as, contrary to conventional GICs or other more conservative securities, they allow you to gain exposure to assets that have a great growth potential.
Some notes provide exposure to asset classes that are difficult to access for most individual investors, such as hedge funds, commodities and credit risk derivatives. These asset classes typically have very little to no correlation to traditional asset classes and therefore add some diversification to your portfolio.
Furthermore, some notes are structured to take advantage of specific market scenarios that are difficult to replicate with a mixture of traditional assets or through investments in options or futures.
Finally, the notes’ return, when redeemed by the issuer at or before maturity, is considered interest income. If the notes are sold before maturity on the secondary market, the return they generate is treated as a capital gain. This is a significant tax advantage, especially for investors who are taxed at a higher marginal tax rate.
Risks associated with linked notes
The risks associated with linked notes usually vary depending on the product structure (protected capital or not) and the underlying assets.
As such, principal-protected notes will only yield the invested capital (without additional returns), while non protected-principal notes can generate additional returns. However, your initial capital is not guaranteed and will vary depending on the market performance.
Finding the right note for your situation
Linked notes are usually manufactured by banks. Since some provide protection of the initial capital – and others do not – you must first determine what you seek in terms of capital preservation. Note that capital protection means that your return potential is more limited than with a product that offers no protection.
Note quotes are usually made available on the issuers’ websites.
Borrowing to purchase linked notes
You can use a margin account to purchase linked notes.
To learn more about margin accounts, please visit our dedicated brokerage account page.
Trading linked notes
To purchase a linked note, please contact one of our representatives at 514 866-6755 / 1-800-363-3511 to place an order with a broker.