Chapter 23 - Structured Products (CSC) PDF

Structured Products 23 CHAPTER OVERVIEW In this chapter, you will learn about the features of structured products in general, including their benefits and risks. You will also learn how different products are s...

Structured Products 23 CHAPTER OVERVIEW In this chapter, you will learn about the features of structured products in general, including their benefits and risks. You will also learn how different products are structured, and what risks and tax implications are associated with the different types. LEARNING OBJECTIVES CONTENT AREAS 1 | Summarize the advantages, disadvantages, Overview of Structured Products and risks of investing in structured products. 2 | Describe the features, risks, benefits, and tax Principal-Protected Notes implications of principal-protected notes. 3 | Describe the structure, risks, and the tax Market-Linked Guaranteed Investment implications of market-linked guaranteed Certificates investment certificates. 4 | Describe the structure, risks, and the tax Split Shares implications of split shares. 5 | Describe the securitization process for asset- Asset-Backed Securities backed securities. 6 | Describe asset-backed commercial paper and mortgage-backed securities. © CANADIAN SECURITIES INSTITUTE 23 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. asset-backed commercial paper principal-protected notes asset-backed securities roll-over risk asset securitization special purpose vehicles capital shares split shares market-linked guaranteed investment structured product certificates tranches mortgage-backed security zero-coupon bond plus option structure mortgage pass-through securities prepayment risk © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 3 INTRODUCTION Structured products provide investors with risk, return, tax, and diversification characteristics not available from conventional investments. The pricing of these products can reference a single security, a basket of securities, an index, commodities, or a combination of assets. They can be designed to provide enhanced yield, capital protection, and tax efficiency—alone or in combination. Structured products were created as an alternative financing method with better terms than those of more conventional products used to raise business capital. These products are not currently subject to National Instrument 81-102, the regulation that governs many aspects of mutual funds. Unlike mutual funds, therefore, they can improve returns by using strategies such as leverage or derivatives. The first structured products were designed to provide returns referenced to well-known securities, indexes, or investments (e.g., S&P 500 Equity Index or the price of gold bullion). These reference securities are called underlying assets. Over time, the underlying assets of structured products have become more varied to attract more capital. As investor interest in the advantages of structured products has grown, so has their availability. Their ability to meet the unique needs of a more and more sophisticated investor market has undoubtedly been one of the factors that has contributed to the success of the structured product market. OVERVIEW OF STRUCTURED PRODUCTS 1 | Summarize the advantages, disadvantages, and risks of investing in structured products. A structured product is a passive investment vehicle that is financially engineered to provide a specific risk and return characteristic. The value of a structured product tracks the returns of the underlying asset. The underlying assets can consist of a single security, a basket of securities, foreign currencies, commodities, or an index. EXAMPLE Examples of underlying assets of structured products Mortgage loans Credit card receivables Car loans Equity indexes Home equity loans Structured products are designed to have less risk than their underlying assets, while providing higher risk-adjusted returns than conventional investments. Investors in these products buy a share of the total pool of underlying assets. Issuers of structured products include established financial institutions, such as banks or consumer finance firms. The issuer takes advantage of economies of scale and market reach to create a package of underlying assets that most people could not afford to assemble on their own. For example, an individual investor would not have access to a pool of mortgage loans with which to create a mortgage-backed security (MBS). Individuals also lack the expertise to evaluate the loans and the ability to assemble them. Banks that issue mortgages, on the other hand, have the expertise and resources to assemble a pool of loans into an MBS. © CANADIAN SECURITIES INSTITUTE 23 4 CANADIAN SECURITIES COURSE      VOLUME 2 TYPES OF STRUCTURED PRODUCTS Structured products are available in different types and formats, including principal-protected notes (PPN), market-linked guaranteed investment certificates (GIC), split shares, MBSs, and asset-backed securities (ABS). Each of these products has specific characteristics. Table 23.1 describes the investment objectives and underlying assets of the various types of structured products. Table 23.1 | Types of Structured Products Product Description Assets Held Principal-protected Bank-issued debt security with returns linked Derivatives, fixed income notes to an equity index, mutual fund, exchange- traded fund (ETF), or basket of stocks Market-linked GICs Bank-issued debt security with returns linked Derivatives, fixed income to an equity index, mutual fund, ETF, or basket of stocks Split shares Equity securities with separate claims on the Dividend-paying stocks dividend and capital cash flow from a holding of underlying stocks Mortgage-backed Medium- to long-term bond with equal claim Residential or commercial securities on the principal and interest cash flows from a mortgages pool of mortgages Asset-backed Short- to medium-term bond with equal claim Consumer loans (home equity, securities on the principal and interest cash flows from a student, auto, and credit card) pool of receivables ADVANTAGES OF STRUCTURED PRODUCTS Structured products have the advantages of professional management, economies of scale, and diversification. They combine high-risk, illiquid securities into one lower risk security that offers higher yields at a given term-to- maturity, compared to a conventional fixed-income instrument. Another advantage is that it is highly likely (although not certain) that the entire principal of a structured product will be returned at the end of the investment period. DISADVANTAGES OF STRUCTURED PRODUCTS One disadvantage of structured products is that, because of their complexity, many investors find it difficult to assess their inherent risks. Structured products that make significant use of derivatives are particularly complex. Also, because structured products have a very thin secondary market, or none at all, illiquidity can be a problem. Some PPN issuers provide a secondary market, but only on a best-efforts basis. In very active or volatile markets, the issuer will either make a market with a very wide bid/ask spread or step aside completely and not support a secondary market. A final disadvantage is that these products often have a large built-in cost structure to compensate for the return guarantee. Investors are often subject to selling commissions, management fees, performance fees, structuring fees, trailer fees, and swap arrangement fees, to name a few. They must therefore overcome a significant cost hurdle before they make a reasonable return. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 5 RISKS INVOLVED WITH STRUCTURED PRODUCTS As with all types of investments, investors in structured products are exposed to general investment risks that include default risk, inflation and interest rate risk, currency risk, and manager risk. Structured products carry an additional risk called prepayment risk. If allowed, based on the structure of the investment, some of the mortgages underlying MBS securities might be paid off earlier than expected. Prepayment shortens the life of the MBS and could potentially leave the investor with a lower return over the life of the structured product. PRINCIPAL-PROTECTED NOTES 2 | Describe the features, risks, benefits, and tax implications of principal-protected notes. In Canada, a PPN is a debt instrument issued by a bank in the form of a deposit note. Like most debt instruments, a PPN has a maturity date on which the issuer promises to return the principal amount (or face value) of the investment. And, like most debt instruments, it also delivers a return in the form of interest. Unlike other debt instruments, however, the interest rate of a PPN is tied to the performance of an underlying asset. The asset might be a portfolio of stocks, an index, or one or more mutual funds or ETFs. Therefore, PPN issuers guarantee only the return of principal at maturity; the interest payment is not guaranteed. Any such payment depends on the performance of the underlying asset. Regulation of PPNs in Canada reflect their structure as bank deposit notes; therefore, they are not considered securities and are not issued under a prospectus. Issuers instead produce information statements that describe the key features and risks of the PPN. DID YOU KNOW? PPNs are subject to regulations under the Bank Act. Although they are issued by banks, they are not insured by the Canada Deposit Insurance Corporation (CDIC). The term to maturity of a PPN varies according to the issue; typically, it ranges from three to eight years. However, notes with shorter or longer terms are also occasionally issued. THE ROLE OF PRINCIPAL-PROTECTED NOTE ISSUERS In Canada, PPNs are issued only by the six major banks (the Big Six). The banks function in three main roles: guarantor, manufacturer, and distributor, as described below. Guarantor As the issuers of PPNs, the banks guarantee the return of principal at maturity. The value of the guarantee is based wholly on the perceived creditworthiness of the issuer. In the event of default, PPN investors rank equally with all other investors in the bank’s deposit notes. Manufacturer As manufacturers, they choose the underlying asset, the term to maturity, and any special features tied to interest payments. This role is almost always performed by a group that specializes in equity derivatives, which is typically part of the bank’s Capital Markets division. Distributor Banks distribute PPNs primarily through their investment dealer arm, although some banks use a third-party investment dealer or mutual fund dealer. © CANADIAN SECURITIES INSTITUTE 23 6 CANADIAN SECURITIES COURSE      VOLUME 2 THE STRUCTURE OF PRINCIPAL-PROTECTED NOTES A PPN is structured to guarantee the investor’s principal and provide for the payment of any interest related to the return on the underlying asset. Theoretically, the issuer puts the sales proceeds into the structure and then manages it to provide the principal and potential interest at maturity. In Canada today, PPN issuers use a structure known as the zero-coupon bond plus option structure. In this structure, the issuer invests most of the proceeds in a zero-coupon bond that has the same maturity as the PPN. The zero-coupon bond guarantees the return of principal at maturity. The remainder of the proceeds is invested in an option on the underlying asset. The option portion of the PPN provides the potential return that funds the payment of interest to investors in the PPN. Using this fairly simple structure, issuers are able to create a large and diverse number of PPNs with different payoffs based on the underlying asset. Two of the most popular types of PPNs issued in Canada are index-linked PPNs, and stock basket-linked PPNs. INDEX-LINKED PRINCIPAL-PROTECTED NOTES With index-linked PPNs, the issuer offers limited exposure to an underlying index such as the S&P/TSX 60 Index. Exposure is limited by one of two means: A participation rate A performance cap INDEX-LINKED PRINCIPAL-PROTECTED NOTES WITH A PARTICIPATION RATE When the issuer uses a participation rate, the final payoff is limited to a percentage of the return on the index. EXAMPLE Your client Jomal invests $5,000 in a five-year PPN linked to the S&P/TSX 60 Index. The PPN has a participation rate of 75%. On the issue date of the PPN, the S&P/TSX 60 Index is 750. Five years later, on the maturity date, the index rises to 1,000. Jomal earns a return of 25% on his investment, calculated as follows: Index Return = [(1,000 ÷ 750) − 1] = 0.33 or 33% Jomal’s Return = 33% × 0.75 participation rate = 0.25 or 25% Therefore, Jomal receives $6,250 on the PPN’s maturity date, calculated as 5,000 × (1 + 0.25) = 6,250 If the S&P/TSX 60 Index had declined to 500 after the five-year period, Jomal would have earned no return; your client would simply be paid his initial principal. INDEX-LINKED PRINCIPAL-PROTECTED NOTES WITH A PERFORMANCE CAP When the issuer uses a performance cap, the final payoff equals 100% of the return on the index but is limited to a predetermined maximum amount. When that limit is reached you do not participate in further growth. EXAMPLE Your client Jolanda invests $5,000 in a five-year PPN linked to the S&P/TSX 60 Index. The PPN has a performance cap of 30%. On the issue date of the PPN, the S&P/TSX 60 Index is 750. Five years later, on the maturity date, the index rises to 1,000. The growth of the index is 33%, calculated as [(1,000 ÷ 750) − 1] = 0.33 or 33%. Jolanda’s return, however, is capped at a maximum of 30%. Therefore, Jolanda receives $6,500 upon maturity, calculated as 5,000 × (1 + 0.30) = 6,500. If the index had risen instead by only 20%, Jolanda would have also earned a return of 20%, because she would not have reached her performance cap. If the return had been negative, your client would have simply got her principal back. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 7 Note: In almost all cases, the return on index-linked PPNs is based on the performance of the price-return version of the index. It does not account for the dividends or distributions paid on its constituents. In effect, investors in an index-linked PPN give up an important source of return that they could potentially earn from direct investment in the underlying index. STOCK BASKET-LINKED PRINCIPAL-PROTECTED NOTES Stock basket-linked PPNs are linked to the average return on a basket of common shares. Typically, the basket contains 10 or 15 different common shares, but it may have more or less than these amounts. With this type of PPN, the return paid to investors is equal to the average return on the individual common shares in the basket. In most cases, the average return on each common share is capped at a pre-set amount, which has the effect of putting a cap on the overall return on the PPN. In some cases, a participation rate is applied to the average return. Finally, some PPN issuers pay a guaranteed minimum return, albeit relatively small, at maturity. Therefore, even if the average return is 0% or less, investors receive something more than just their principal back. EXAMPLE Your client Simon invests $5,000 in a six-year PPN linked to the average return on a basket of 10 common shares. A maximum return of 50% is attributable to any one common share. The PPN has no minimum guaranteed return above the principal amount. The starting and ending share price of each common share is shown in Table 23.2, along with the actual return and effective return. Table 23.2 | Prices and Returns of a Six-Year Principal-Protected Note Common Share Starting Price Ending Price Actual Return Effective Return 1 $20 $25 25% 25% 2 $10 $8 −20% −20% 3 $50 $55 10% 10% 4 $35 $35 0% 0% 5 $40 $36 −10% −10% 6 $75 $150 100% 50% 7 $60 $72 20% 20% 8 $30 $21 −30% −30% 9 $40 $60 50% 50% 10 $100 $125 25% 25% Note: The effective return for the holder of the PPN is capped at a maximum of 50%. Therefore, the actual return on Common Share #6 was 100% over the six-year period, whereas the effective return was only 50%. The overall return on Simon’s PPN is equal to the average of the effective returns, which is calculated as follows: Effective Return Average = (25% − 20% + 10% + 0% − 10% + 50% + 20% − 30% + 50% + 25%) ÷ 10 = 12% Therefore, Simon receives $5,600 on the maturity date, calculated as 5,000 × (1 + 0.12) = 5,600. However, if the average effective return on the common shares was equal to or less than 0%, Simon would have earned no return; he would simply be paid his initial principal. © CANADIAN SECURITIES INSTITUTE 23 8 CANADIAN SECURITIES COURSE      VOLUME 2 Note: As mentioned earlier, this type of PPN almost always excludes the payment of any dividends or distributions from the calculation of the return on the common shares. FEATURES AND PERFORMANCE FACTORS OF PRINCIPAL-PROTECTED NOTES What are the features of PPNs and how are PPN returns calculated with performance caps and participation rates? Complete the online learning activity to assess your knowledge. RISKS ASSOCIATED WITH PRINCIPAL-PROTECTED NOTES PPNs are often perceived as risk-free investments because the principal is guaranteed at maturity. However, although their risk is potentially lower than that of equity investments, PPNs do not avoid all risks. The unique set of risks carried by PPNs are outlined below. Liquidity Risk Many PPNs offer investors the opportunity to redeem their investment before maturity. This feature gives PPNs a distinct advantage over similar GIC-based products, which must be held until maturity. However, the price at which the issuer offers to buy back a PPN may not be the security’s fair value; it may include embedded fees charged for early redemption. No method exists for investors to determine what a PPN’s fair value is at any given time. Therefore, they have no way of knowing what portion of the price represents fees. Also, although issuers may offer to facilitate a secondary market, they are under no obligation to do so. Performance Risk The performance of the PPN may be lower than that of the underlying asset. Among the many factors involved in pricing a PPN is the cost of principal protection. That cost is reflected in the PPN’s return; therefore, the return is unlikely to exactly match the returns of the underlying asset. Credit Risk Although PPNs are guaranteed by the banks that issue them, they are not insured by CDIC. Most investors are comfortable with today’s credit risk of Canada’s Big Six banks; however, no bank’s credit status is unchangeable. Investors should therefore consider the possibility that the issuer will be unable to return their principal at maturity. Currency Risk Some PPNs are structured to track the returns from a foreign currency-denominated underlying asset or assets. Unless specified otherwise in the PPN’s offering documents, a PPN based on a foreign asset exposes investors to currency risk. IMPORTANT FACTORS TO CONSIDER WITH PRINCIPAL-PROTECTED NOTES PPNs are not appropriate for investors who require either a predictable stream of income or liquidity to fund their lifestyle. The reasons for these two considerations are explained below. Need for predictable Although some newer PPNs are designed to provide income, the income stream is usually income not guaranteed. In most cases, PPNs that do provide income offer a below- market yield over their term. Also, many PPNs specifically exclude interim income distributions. Need for liquidity Liquidity is not guaranteed with PPNs. Although the issuer may offer to facilitate a secondary market, it is under no obligation to do so. Even if it does regularly facilitate a secondary market, the bid price may not accurately reflect the note’s economic performance or its value before maturity. An investor should be prepared to hold a PPN until its maturity date. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 9 Market volatility, which has been a factor in recent years, may make the idea of a principal-protected investment more appealing for some of your clients. However, you should help your clients determine whether they really need the protection that PPNs offer. Investors with an average or above-average risk profile and a sufficiently long investment time horizon should consider other options. They may find that a properly diversified portfolio outperforms a PPN over the long term, while avoiding their inherent risks and keeping volatility at an acceptable level. TAX TREATMENT OF PRINCIPAL-PROTECTED NOTES Any return from a PPN held to maturity or generated prior to maturity by way of sale is generally taxed as interest income. For example, suppose your client put $10,000 into a PPN and sold the investment for $11,500 two years prior to maturity. The $1,500 gain would be treated as interest income in the year in which the PPN was sold. The tax treatment for PPNs is spelled out in the PPN’s offering document. MARKET-LINKED GUARANTEED INVESTMENT CERTIFICATES 3 | Describe the structure, risks, and the tax implications of market-linked guaranteed investment certificates. GICs are a type of fixed-income security that offers fixed or variable rates of interest for a specific term. The issuing institution guarantees both principal and interest payments, and the investment is insured by the CDIC. Market- linked GICs are a customized product that links returns to the return on an underlying asset such as a stock index, mutual fund, or ETF. STRUCTURE OF MARKET-LINKED GUARANTEED INVESTMENT CERTIFICATES GICs linked to an index, mutual fund, or ETF combine the guarantee of the principal with some of the growth potential of an equity investment. Their popularity has grown in light of recent bouts of market volatility and historically low interest rates. These GICs may be especially popular among your clients who are conservative investors and want the guaranteed security of a GIC, but who also want some exposure to the stock market. Market-linked GICs are typically offered with three- and five-year terms and are usually non-redeemable until maturity. They may be indexed to domestic or global indexes, or to a combination of benchmarks, as well as mutual funds with various mandates and ETFs. The principal of a market-linked GIC is guaranteed, but the total return on the instrument is not known until maturity. It may be limited either by a maximum cap on returns or by a participation rate, depending on the issuer. If the underlying index, mutual fund, or ETF falls in value over the term during which the instrument is held, all that is returned to the investor is the original principal invested. Therefore, your clients must weigh the risks that the underlying asset could decline over the period that they hold the investment. CALCULATING RETURNS ON A MARKET-LINKED GUARANTEED INVESTMENT CERTIFICATE The calculation of the overall return on a market-linked GIC may vary among issuers and the underlying asset. With an index-linked GIC, for example, the following variables are generally used: The initial index level The ending index level © CANADIAN SECURITIES INSTITUTE 23 10 CANADIAN SECURITIES COURSE      VOLUME 2 Index growth over the term The performance cap or participation rate, if any EXAMPLE Your client Manish has a $10,000 investment in a five-year XYZ Market-Linked GIC. Return on the GIC is based on the performance of the S&P/TSX Composite Index, with a 60% participation rate. The overall return on this instrument is shown in Table 23.3. Table 23.3 | Overall Return on XYZ Market-Linked Guaranteed Investment Certificate Initial Index Index Growth over Level Ending Index Level the Period Participation Rate Overall Return 8,600 12,000 39.53% 60% 23.72% Index Growth = (Ending Index Level − Initial Index Level) ÷ Initial Index Level × 100 Overall Return = Index Growth × Participation Rate To calculate the total return earned over the term, simply multiply the amount of the principal invested by the overall return. Therefore, Manish earned $2,372, which is calculated as follows: Total Interest Earned = Principal × Overall Return = 10,000 × 23.72% = 2,372 Different GICs have different underlying benchmarks, which can make it difficult to compare performance. However, some features can, and should, be compared when considering an investment in an index-linked GIC. Along with different underlying benchmarks, the terms of these securities may vary as follows: Some GICs base returns on the level of the index on a particular date; others use the average return for a number of periods during the GIC’s term. Some GICs allow investors to lock in returns as of a given period; others allow early redemptions at specific dates, such as a one-year anniversary. DID YOU KNOW? Averaging provisions reduce the effect of a sharp market plunge just before maturity. However, they also reduce the investor’s returns in a gradually rising market. RISK ASSOCIATED WITH MARKET-LINKED GUARANTEED INVESTMENT CERTIFICATES If your clients invest in market-linked GICs, they must accept the risks associated with an investment that tracks the performance of the stock market, a mutual fund, or an ETF. The main risk is that the index or fund will either remain stagnant or fall over the GIC’s term. Regardless of what happens to the underlying investment, 100% of the principal will always be returned at the end of the term. However, your clients must be willing to accept the risk that the investment may generate no return. A secondary risk is that, in most cases, your clients will not be allowed to redeem market-linked GICs prior to the maturity date. They must therefore also be prepared to hold the instrument to maturity. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 11 TAX IMPLICATIONS OF A MARKET-LINKED GUARANTEED INVESTMENT CERTIFICATE The returns on market-linked GICs, if any, are classified as interest income. If the instrument is purchased outside of a registered retirement savings plan (RRSP), the gains are added to income and taxed at the investor’s marginal tax rate. And because the return is deferred to the maturity of the GIC, the interest income realized is all taxed in the year of maturity. Consequently, depending on your clients’ tax situation, market-linked GICs may not be the most tax efficient investments for them. Your clients may be better suited to hold market-linked GICs in registered plans, such as RRSPs and tax-free savings accounts. SPLIT SHARES 4 | Describe the structure, risks, and the tax implications of split shares. A split share is a security that divides the investment attributes of an underlying portfolio of common shares into separate components. Each component satisfies a different investment objective. These investment vehicles are created by a type of closed-end fund known as split share corporations. The shares created by the split are listed and trade on a stock exchange. The split share corporation holds common shares of one or more common stock issuers. The corporation then issues two types of shares: preferred shares and capital shares. Preferred shares These shares receive the majority of the dividends from the common shares held by the split share corporation. Preferred shares appeal to equity investors willing to sacrifice capital gain in favour of dividend income. Capital shares These shares receive the majority of any capital gains on the common shares. Capital shares appeal to equity investors who are willing to sacrifice dividend income in favour of capital gains. In a typical split-share issue, the preferred share has a priority claim on all available dividends from the underlying portfolio of common shares. The preferred share is also entitled to a priority claim on the capital of the portfolio up to a certain value. The capital share receives all the capital appreciation on the portfolio above what the preferred share is entitled to. The capital share may also receive dividends after the preferred share dividend has been paid. In many ways, split shares are akin to two different clients teaming up to buy a single stock. One of your clients (the preferred share investor) chooses the priority claim on the dividends in exchange for capital appreciation. The other client (the capital share investor) relinquishes the first claim on dividends in exchange for all the price appreciation above a certain value. Your capital share client is willing to give up dividends on the underlying common shares in exchange for a leveraged investment in those shares. Split shares are issued for a specific term, as stated in the prospectus, ranging from three to more than 10 years. At the end of the term, the split-share company redeems the shares. At that point, the owners of the preferred shares receive back their principal investment and any other obligations owed. The capital shareholders then receive the remaining value. © CANADIAN SECURITIES INSTITUTE 23 12 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Assume that the common shares of ABC Corp. trade at $50 and pay an annual dividend of $1.50 (representing a 3% dividend yield). To create a split share based on ABC Corp., an investment dealer purchases ABC Corp.’s common shares and places them in an investment trust called ABC Split Corp. The trust then issues one ABC Split Corp. preferred share at a price of $25 for each ABC Corp. common share that the trust holds. Holders of the preferred shares receive the entire $1.50 dividend from the ABC Corp. common share, which represents a yield of 6%. In other words, the preferred share earns twice the dividend yield of the common share because only half as much money is required to earn the same amount. In exchange for the higher yield, the preferred share is entitled to only the first $25 of the value of each ABC Corp. common share that ABC Split Corp. owns. ABC Split Corp. also issues one ABC Split Corp. capital share, priced at $25, for each common share held in the trust. The capital share owners are entitled to all the capital appreciation of ABC Corp. above $25 per share for the term of the split-share corporation. DID YOU KNOW? Unlike regular common shareholders, investors who purchase capital shares from the split share corporation have purchased a leveraged position. In the example above, suppose that a common shareholder purchases ABC Corp. common shares for $50 per share. If the price of the common shares increases by $5 to $55 per share, that investor would experience a 10% gain. However, the capital share owner would experience a 20% gain, because a $5 increase in value is based on the capital share owner’s $25 per share investment. The reverse also holds true. A drop in the value of the underlying common shares leads to a greater drop in value for the capital shareholder, compared to the regular common shareholder. RISKS ASSOCIATED WITH SPLIT SHARES Both capital and preferred shares are influenced by the financial health of the underlying portfolio shares. Both types of shares also depend on good management of the split-share corporation. In particular, management must be vigilant to keep costs down and monitor the underlying portfolio. Some managed funds use options and leverage (i.e., borrowing for investment) to increase profit. These strategies increase risk for the investors but can also improve their opportunities for profit. CAPITAL SHARE RISKS Capital shares hold much more risk than preferred shares for the following two reasons: They are ranked after preferred shares in priority, in the event that the split-share corporation is wound up. They are not paid until after obligations to preferred holders, along with other liabilities, are paid. Capital shareholders face three risks in particular: inherent leverage, volatility, and dividend cuts. Inherent leverage They can lose the entire value of their investment if the underlying portfolio of common shares declines sufficiently. Capital share investors must be comfortable with both the investment outlook for the common shares and with the capital share’s leverage factor. Volatility Capital shares are a leveraged investment in a portfolio of underlying common shares and are therefore volatile. A study of price volatility (reported by Scotia Capital) revealed that capital shares tend to be significantly more volatile than the common shares held in the underlying portfolio, and therefore carry more risk. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 13 Dividend Cuts Capital shares may not receive dividends, but they are nevertheless susceptible to dividend cuts, especially when the corresponding preferred shares have a guaranteed dividend. A rate cut means that more portfolio shares must be sold to pay the dividends, which results in less value for holders of capital shares. PREFERRED SHARE RISKS Despite their priority claim over capital shares on both dividends and capital, split preferred shares are not without uncertainty. For example, a split-share corporation often reserves the right to wind up earlier than the stated maturity date, if the asset value falls below a specific level. In such cases, the corporation redeems the preferred shares early, which presents certain risks for the investor. These risks, and others, are explained below. Reinvestment risk Investors in split preferred shares lock in a rate of return on the purchase of a preferred share. If the shares are redeemed prior to maturity, the investors must find replacement investments, which may provide lower yields and fewer tax advantages. Early redemption When investors purchase split shares, they may pay a premium. If the split preferred shares are redeemed early, investors lose the premium. They should understand this risk and, if paying a price higher than redemption value, they should know the yield-to- call. Yield-to-call refers to the rate of return you would receive if you were to hold the investment until the call date, given that the shares were called. Credit risk Credit risk is the risk of change in the creditworthiness of the preferred share issuer as defined by a credit-rating agency. A reduced rating increases the yield demanded by the market, and thus tends to lower the price of preferred shares. Decline in value of the A significant decline in the value of the underlying portfolio can reduce the price of split underlying portfolio preferred shares. However, the shares are afforded a fairly generous degree of protection at issue, represented by the value of the capital share. As well, a decline in the value of the underlying common shares would have to be sustained over the life of the split preferred share. Investors can measure the amount of downside protection by comparing the split-share unit’s net asset value with the redemption price of the split preferred share. Taxation risk An attractive feature of preferred shares is that the tax rate applied to dividend income they earn is lower than that applied to interest income. The relative appeal of this feature, however, depends on the investor’s marginal tax bracket and province of residence. Investors should be aware that the tax rate on preferred shares could change if the government alters their status as flow-through entities. The tax rules for dividends and capital gains could also change. As well, any change in taxation rates in general could alter the relative attractiveness of these shares. Dividend cuts If the dividends on the underlying shares are cut or eliminated, the value of the split preferred shares is reduced, especially when the split-share dividend is tied to the portfolio dividend. If a split preferred share has a fixed dividend, and if portfolio dividends are too low to cover that dividend, portfolio shares must be sold to top up the dividend. Because this activity reduces the net asset value of the corporation, the downside risk of the preferred shares increases. © CANADIAN SECURITIES INSTITUTE 23 14 CANADIAN SECURITIES COURSE      VOLUME 2 TAX IMPLICATIONS OF SPLIT SHARES Split-share corporations are a type of closed-end fund. As such, after they have covered all costs of running the corporation, they pay out all remaining profits to their shareholders. When the corporation passes this net income on to the shareholders, it pays no income tax. Instead, the income is taxed in the shareholder’s hands. Therefore, even if capital shares are designed to receive no income until the end of their term, they may still receive dividends from profits that are not owed to preferred holders. These profits may arise from portfolio sales required as a result of a merger or from rising dividends. In such cases, capital shareholders must declare that income and pay tax on it. ASSET-BACKED SECURITIES 5 | Describe the securitization process for asset-backed securities. 6 | Describe asset-backed commercial paper and mortgage-backed securities. Asset securitization is a process that makes products like mortgage-backed and other asset-backed securities possible. Asset securitization aggregates financial assets such as mortgages, loans, and other receivables and transforms them into marketable securities. Numerous financial institutions use this process to transfer the credit risk of the assets on their statement of financial position to large institutional investors. Given their financial expertise, these institutional investors are able and willing to assume the risk of the underlying assets and the unique characteristics of the securities in which they are packaged. Financial institutions often sell these securitized products to reduce their need to establish capital reserves for the underlying assets. By relinquishing these assets, they free up capital to pursue business opportunities and make further loans. THE SECURITIZATION PROCESS In its most basic form, securitization is a three-step process involving the originator of the assets to be securitized, the special purpose vehicle (SPV) set up to purchase and manage the assets, and the issuer that controls the SPV and issues ABSs to investors. The three steps are as follows: 1. The originator, a company with income-producing assets, groups together assets it wants to remove from its statement of financial position. It pools these assets together into a reference portfolio. 2. The originator sells the pooled assets to an SPV controlled by the issuer. The SPV is set up for the sole purpose of purchasing the assets to take them off the originator’s statement of financial position. 3. The issuer finances the purchase of these assets by the SPV by selling marketable securities called ABSs to investors. The investors include large financial institutions and managers of large pools of capital, such as life insurance companies, pension plans, mutual funds, and hedge funds. Typically, the originator services the original income-producing assets for a fee, and then passes the net amount of interest income directly to the SPV. The SPV then redistributes this net amount to the various investors in the ABS. The investors receive either fixed or floating-rate interest payments. With the cash received from the SPV in exchange for the reference assets, the originator is now able to expand its loan or asset portfolio. The originator often repeats the securitization process in a cycle. The ABS investor now has a claim on the cash flows emanating from the assets owned by the SPV. Because of their unique characteristics, ABS products are used by institutional investors to diversify their portfolios. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 15 The securitization process is depicted in Figure 23.1. Figure 23.1 | Asset-Backed Securitization Process Sells Assets to Sells ABS to SPV for Cash Investors for Cash Asset Originator Issuer (SPV) Investor Creates Buys And Holds Receives all Cash Flows Reference Portfolio Reference Portfolio From SPV (Less Servicing Fee) In its most basic form, the SPV issues only one class of ABS. Accordingly, each ABS investor has a claim on the SPV’s assets and cash flows in direct proportion to the amount it owns. However, with increasing investor interest, the ABS market has become more sophisticated and ABS design more complex. Most ABS securities now divide the reference portfolio into a number of classes, commonly called tranches. Each tranche has its own level of credit risk and either a fixed or variable rate of return. The tranches are sold separately to investors who seek the appropriate risk-to-return opportunity from the SPV’s assets. Both the investment return (including principal and interest payments) and losses are allocated among the various tranches, according to their seniority in the SPV. The standard securitization scheme assumes the three-tier tranche hierarchy described below. Senior The most creditworthy level, the senior tranche, has the first claim on any income generated by the SPV. It is normally the largest of the three levels, has the least amount of credit loss risk associated with it, and attracts the most credit-sensitive type of investor. Mezzanine Until this tranche is fully paid, the junior tranche is not entitled to any interest payments. Junior Investors in this least creditworthy tranche hope that there will be sufficient interest payments remaining to satisfy their claims when their time comes. This tranche is normally the smallest of the three. It has the greatest amount of credit risk and attracts investors who are more comfortable assessing and assuming risk. They expect to be compensated for the higher risk with a higher rate of return. ASSET-BACKED COMMERCIAL PAPER Asset-backed commercial paper (ABCP) is a type of ABS with a maturity date of less than one year (typically in the range of 90 to 180 days). Otherwise, it has the same legal and design structure as a standard ABS. This product was initially designed to minimize roll-over risk by matching short-lived assets with short-term funding. Roll-over risk for an ABCP is the risk that the issuer will be unable to refinance or renew the underlying assets when the ABCP matures. Repayment of a maturing ABCP normally depends on the cash flows emanating from the assets owned by the SPV. It also depends on the ability of the ABCP issuer to issue new ABCP to replace the maturing one (or renew the current one). If the ABCP is based on easily understood and easily valued assets, and if capital markets are stable and liquidity conditions good, the roll-over risk is relatively low. Over time, however, parts of the ABCP market have © CANADIAN SECURITIES INSTITUTE 23 16 CANADIAN SECURITIES COURSE      VOLUME 2 become more and more complex. Accordingly, ABCP has become increasingly difficult to understand, and therefore increasingly risky. FOR INFORMATION ONLY Canadian ABCP Crisis Canada experienced its own financial crisis in 2007, when a number of issuers of non-bank managed ABCP announced that it was not possible to renew outstanding ABCP because conditions in the Canadian capital markets were unfavourable. Apparently, an increasing number of ABCP trusts held an ever-increasing share of U.S. residential mortgage loans. At that time, the U.S. housing and mortgage crisis was growing, and news of its imploding prime market was spreading. Investors in Canadian ABCP became concerned that Canadian ABCP issuer SPVs could face material credit losses as a direct result of their subprime mortgage exposure. In response to deteriorating market conditions, many ABCP issuers and sponsors decided to extend the maturity date on ABCP that had extension date features. Most banks declined requests for liquidity on the basis that current capital market conditions did not satisfy the market disruption clauses in their liquidity guarantee agreements. Therefore, most SPVs were unable to repay holders of ABCP on their stated maturity date. The decision by the non-bank ABCP liquidity guarantors formed the core of the Canadian ABCP crisis. The vast majority of these providers were domestic branches or affiliates of various foreign banks (Schedule II banks). Most large Canadian Schedule I banks, in issuing ABCP securities, used the same bankruptcy-remote SPV structure employed by the non-bank, third-party ABCP issuers. Despite the legal remoteness of their ABCP SPVs, Schedule I banks voluntarily honoured all redemption and maturity-related aspects of their ABCP issues. They had the following three reasons for doing so: To help ensure the stability of the ABCP market To avoid possible spillover panic into other areas of the money and short-term funding markets To avoid damage to their reputations The Canadian ABCP market is divided into the following two parts: ABCP issued and guaranteed by chartered banks (Schedule I) ABCP issued by SPVs sponsored or guaranteed by non-banks (non-Schedule I) At its peak in early 2007, the total Canadian ABCP market was estimated at over $120 billion. The ABCP liquidity crisis was extensive: the non-bank, or third-party, sponsored portion of the Canadian ABCP market was estimated at about $32 billion. Among several factors that contributed to the ABCP crisis, the following three factors were most important: A mismatch between the maturity of the ABCP and the maturity dates of the associated underlying assets (in the SPV) ABCP investment in assets, and derivatives on those assets, that had substantial credit risk Common product design legal terms that were not sufficiently clear about proper interpretation of non- bank, third-party liquidity guarantee clauses; in particular, the definition of market disruption For investment advisors, one of the most important lessons of the Canadian ABCP crisis was that many investors were not aware of the nature and type of investments underlying their ABCP investments. This lack of transparency is one of the hallmarks of ill-designed investment vehicles. As an advisor, transparency should be your paramount concern when you are considering new investment vehicles such as structured products and hedge funds for your clients’ portfolios. It is essential that both you and your clients understand what you are recommending. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 17 MORTGAGE-BACKED SECURITIES MBSs are a class of income-producing structured product designed to provide liquidity in the illiquid mortgage market. Introduced in 1986, MBS issues trade in the secondary market and have become a routine part of the mortgage industry. Also known as mortgage pass-through securities, these products are a type of bond that claims ownership to a portion of the cash flows from a pool of mortgages. An intermediary collects the monthly payments from the issuers of the mortgages and, after deducting a fee, remits them (i.e., passes them through) to the MBS holders. Therefore, every month, holders receive a proportional share of the interest and principal payments associated with the mortgages. MBSs are similar to other bonds in the following ways: They carry interest rate risk, which increases with the length of the term to maturity. They carry credit risk, which is the risk of change in the creditworthiness of the issuer, or that the issuer will be unable to pay the bond’s coupons and principal at the maturity date. Their prices are inversely related to interest rates, which means that their market price drops when interest rates rise, and vice versa. Unlike bonds, however, many MBSs also have prepayment risk, particularly those issued in the U.S. bond market and a portion of those issued in the Canadian market. The nature of residential mortgages in United States and Canada is such that homeowners may elect to prepay their mortgage principal (i.e., pay down a portion of the principal ahead of schedule). Because residential mortgages form part of the pools of mortgages that underlie the MBS, the risk of prepayment becomes an inherent part of the security. In both the Canadian and U.S. MBS market, the vast majority of MBSs are assumed to be of AAA credit quality. This is because they are issued with either an explicit or implicit government guarantee of timely payment of interest and principal in the event of delinquency or default of the borrower. STRUCTURE AND BENEFITS OF MORTGAGE-BACKED SECURITIES In Canada, the security backing the underlying mortgages in an MBS is residential properties—single-family, multi- family, or social housing. The properties are fully insured by the Canada Mortgage and Housing Corporation (CMHC) as to interest, principal, and timely payment. There is no limit to the size of holding that can be insured. National Housing Act (NHA) MBSs can be structured with an open or a closed pool. Open mortgages may have provisions for prepayment, which can have significant effects on the cash flows and yields. Therefore, MBSs are composed separately of prepayable (open) and non-prepayable (closed) mortgages, as follows: In an open NHA MBS, the owners of the underlying properties can prepay the principal. The return and pricing of an open MBS is therefore somewhat uncertain because of the unsteady or unpredictable cash flows. Closed mortgage pools are made up of social housing and multiple-family home mortgages. Because prepayment of principal is not allowed with closed NHA MBS, cash flows and pricing are more certain than with open mortgage pools. DID YOU KNOW? When interest rates are falling, it is profitable for property owners to prepay their open mortgages and refinance the property at a lower rate. For this reason, the realized yields on prepayable MBSs are lower than the yields expected based on the interest rates of the component mortgages. The income stream of an MBS is a combination of interest and scheduled principal payments. It can also include prepayments and any prepayment penalties. Deductions are made for servicing and guarantee fees as well. Terms of an MBS can be as short as three years or longer than 10 years. Any principal not yet prepaid at maturity is returned to the investor. © CANADIAN SECURITIES INSTITUTE 23 18 CANADIAN SECURITIES COURSE      VOLUME 2 Monthly payments occur on the 15th day of each month, rather than on the first day. This delay reflects the time spent collecting mortgage payments and calculating the new outstanding mortgage balances. This payment method has a cost at the end of term, when the remaining principal is returned to the holders. A significant loss can incur on a large holding over the two-week period. One of the primary benefits of an MBS is its monthly income stream, which makes it well-suited to provide retirement income. Also, the only part of the income stream that is taxable is the interest income; the return of principal is not taxable. These securities are fully liquid and can be sold at market value at any time. Your clients who choose to invest in a CMHC-guaranteed MBS effectively place their money in real estate without the risk of default, and without the problems of collection and credit appraisal. The most common MBSs are five-year pools denominated in multiples of $5,000. An MBS earns a return that is comparable to a GIC, typically higher than that of a Treasury bill (T-bill) or other Government of Canada bond with similar terms. Because the Government of Canada stands behind the CMHC guarantee, MBSs are roughly equal in security to Government of Canada T-bills and bonds. As such, one would expect the yields to be virtually the same as those of government bonds. In fact, there is a clear yield premium on the MBS. MBSs have several benefits and various risks, which are detailed below. Benefits They are fully guaranteed by the Government of Canada as to principal, interest, and timing of payments, when held to maturity. The CMHC guarantee does not limit the holding’s size. Guaranteed monthly payments are provided. Yields are higher than the equivalent maturity Government of Canada bonds. They are very liquid. A low minimum investment is required (usually $5,000). They are eligible to be held within an RRSP, registered retirement income fund, or tax-free savings account. Risks The prepayment possibility on prepayable MBSs introduces reinvestment risk. If rates decline, it may not be possible to find the same attractive yield. For a prepayable MBS issue, increased payments might be received when unscheduled payments are made by the borrowers. Extra payments may also include bonuses or penalties. Both these situations reduce future interest payments. If a mortgage loan goes into default, all MBS investors may receive the full payment of the principal of a mortgage loan before the scheduled maturity date. When that happens, interest payments from that property come to an end. Similarly, if the mortgage property is damaged, legal action may result in the liquidation of the loan from the NHA MBS pool. Although MBSs are liquid, if market rates have increased and there is still a considerable time to maturity, a capital loss might be incurred when they are sold. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 23      STRUCTURED PRODUCTS 23 19 SUMMARY In this chapter, we discussed the following key aspects of structured products: PPNs are debt-like instruments with a maturity date, whereby the issuer agrees to repay investors the amount originally invested (the principal) plus interest. They are issued by chartered banks, but they are not protected by the CDIC. Two of the most popular types of PPNs issued in Canada are index-linked PPNs, with a participation rate or performance cap, and stock basket-linked PPNs. PPNs are inappropriate for investors who rely on a regular and predicable investment income. Market-linked GICs combine the safety of a guaranteed principal with some of the growth potential of an underlying asset or benchmark. The total return may be limited either by a maximum cap on returns or by a participation rate. In most cases, investors cannot redeem market-linked GICs prior to the maturity date. The return on these investments is taxed as interest income. Split shares separate the investment attributes of an underlying portfolio of common shares into preferred share and capital share components. The preferred shares receive the majority of the dividends from the common shares held by the split share corporation. The capital shares receive the majority of any capital gains on the common shares. Split shares are issued for a specific term stated in the prospectus; at the end of the term, the split-share company redeems the shares. Asset securitization is a process that aggregates and transforms financial assets such as mortgages, loans, and other receivables into marketable securities called ABSs. The originator of the ABS groups assets together to remove them from its statement of financial position. The assets are pooled into a reference portfolio and then sold to a separate legal entity called an SPV. Marketable securities are then sold against the SPV. Most ABS securities divide the reference portfolio into tranches with different levels of risk and reward. ABCP is a particular type of ABS with a maturity date of less than one year. Repayment of a maturing ABCP normally depends on the cash flows emanating from the assets owned by the SPV, as well as the ability of the ABCP issuer to issue a new ABCP (or renew the current one). MBSs are bonds that claim ownership to a portion of the cash flows from a group or pool of mortgages. Most MBSs are assumed to be of AAA credit quality, because they are issued with a government guarantee that interest and principal will be repaid. The underlying mortgages in an MBS may have provisions for prepayment, which can have a significant effect on cash flows and yields. The securities are therefore structured with either an open (prepayable) or closed (non-prepayable) mortgage pool. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 23 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 23 FAQs. © CANADIAN SECURITIES INSTITUTE