24 - Structured Products Flashcards
What are the 3 main types of PPNs?
- Index-linked notes
- Mutual fund-linked notes
- Hedge fund-linked notes
What are the five main types of structured products?
- Principal-protected note (PPN)
- Index-linked GICs
- Split shares
- Asset-backed securities (ABS)
- Mortgage-backed securities (MBS)
What are maturity terms for Index-linked vs Mutual fund-linked notes?
Index: 3-5 years
MF: 6-8 years
What three entities are involved with bringing PPNs to market?
- Guarantor (sched I or II banks)
- Manufacturer (big six banks)
- Distributor (invest/MF dealers)
How does a zero-coupon bond plus call option PPN protect the principal and provide return?
Most funds go into a zero coupon bond with maturity date in several years to protect principal. The rest goes into buying call options on the underlying asset (growth potential).
How does a “constant proportion portfolio insurance” (CPPI) structure work?
Shifts the portfolio’s allocation between a risky asset and a risk-free one, based on changes in interest rates and the value of the risky asset.
What are 5 risks related to PPNs?
- Liquidity risk
- Performance risk
- Call risk
- Credit risk
- Currency risk
How is a PPN taxed if it is held to maturity?
Any gain in NAV is treated as interest income in the year it matures.
How is a PPN taxed if it is redeemed before maturity?
CRA hasn’t decided. Most in the investment community think it should be a cap gain/loss, but who knows what CRA will decide?
What does a “maximum cap on returns” provision mean?
The investment cannot yield more than the maximum return allowed by the issuer. (Index-linked GICs)
What is a participation rate?
It means the performance of an index-linked GIC will be equal to a percentage of the underlying index’s performance. (E.g. If index returns 20% and participation rate is 80%, then GIC returns 16%)
What is the formula to determine total interest earned on an Index-linked GIC?
Principal x ((end - initial)/initial x 100) x (Participation Rate)
What are a couple risks of Index-linked GICs?
- The index might not increase
2. Cannot redeem prior to maturity
How are Index-linked GICs taxed?
As interest income in the year of maturity.
How do split shares work?
Purchases common stock of a dividend yielding company, and splits them into: preferred shares (only dividends, no cap gains) and capital shares (no dividends, only cap gains)
What are three risks of split share “Capital Shares”?
- Inherent leverage (can lose all)
- Volatility (more than common shares)
- Dividend cuts (since preferred are guaranteed a dividend, shares might need to be sold to maintain that amt)
What are 7 risks of split “Preferred shares”?
- Early closing (gotta find a replacement investment)
- Early redemption
- Decline in value of underlying portfolio
- Reinvestment risk
- Taxation risks
- Credit risk
- Dividend cuts
What are the two steps of the securitization process?
- Originator pools assets it wants to remove from its balance sheet and sells them to a Special Purpose Vehicle (separate legal entity)
- Issuer (SPV) sells Asset-Backed Securities to investors for cash
What are tranches?
Divisions of an ABS’s reference portfolio that provide different levels of risk and reward.
What is the standard 3-tier tranche hierarchy? (From highest to lowest)
- Senior
- Mezzanine
- Junior
What is the typical maturity date of Asset-Backed Commercial Paper?
Less than one year (90-180 days)
What type of risk are Asset-backed Commercial Paper ABSs meant to protect against? (And when does it fail at that?)
Roll-over risk
fails when the underlying assets are not well understood or easily valued and capital markets have poor liquidity
What is another term for mortgage pass-through securities?
Mortgage-backed securities
What credit quality do most MBSs have in US and Canada, and why?
AAA quality (because gov guarantees payment of interest and principal in the event of delinquency or default of the borrower)
What is a risk specific to MBSs that most other bonds do not have?
Prepayment risk (open mortgage)
What type of MBSs are guaranteed by CMHC?
National Housing Act (NHA) MBSs
What are 6 benefits of NHA MBSs?
- Fully guaranteed by Gov of Cda (no limit to holding size)
- Guaranteed monthly payments (interest and principal)
- Yields are higher than Gov of Cda Bonds
- Very liquid
- Low min investment ($5k)
- Can be held in RRSP or RRIF
What are 6 risks associated with NHA MBSs?
- Reinvestment risk (if prepaid)
- Increased payments (reduce future interest)
- If loan defaults, get only principal back
- Property damage = legal action
- Capital is returned through term not at the end
- Capital loses if sold when market rates increase with long term remaining
