Are they good? Are they bad? Are they another evil product created by banks for (banks) their clients? One thing is for sure, linked notes have been a very popular type of investments within the bear market. What is a linked note anyway? At first glance, it seems to be a perfect pick for any investors: A linked notes is a capital guaranteed investment offering unlimited potential of return. It seems that we found the Klondyke, didn’t we?
As it is the case with the Klondyke, linked notes may seem delicious during the first lick but it hides trans fat and a thousand of calories. This is the price to pay to have performing guaranteed investments ;-).
How does it work for the client?
The client purchases the note and the amount is frozen for a 5 to 8 years term. The note is linked to a predetermined asset (i.e. TSX index or a basket of international stocks). At the end of the term, the client is 100% assured to get his capital back, plus the investment return of the asset, minus management fees. At mid term, the bank usually has a clause allowing the financial institution to buy back the notes (if the underlying asset outperforms their prediction). If they do so, they have to pay a predetermined return to the client (let say 9-10% per year).
How does it work for the bank?
In order to cover their risk, they take about 60% to 70% of the money and invest it in fixed income at a 5% to 6% rate. In 8 years, this amount will give enough to pay back the client’s capital. The other part (the 30% to 40% of the amount) is invested in the market (without management fees since they manage the money for themselves). So if the underlying asset does 11%, they make the 11% and take off about 3% in management from the client. This is the price to pay for having capital guaranteed investment doubled with unlimited potential of return. If the asset did more than 9% at mid term, they simply buy back the note from the client and take the difference from themselves. If investments (both on the fixed income side and the market side) are done carefully, this could be a very profitable business for both the client and the bank.
So is it an evil product or not?
Depending on the type of investor you are, linked notes maybe represent your only chance to beat the 3.5% GIC rates without taking risks or it could result in a total waste of potential return. In theory, if you invest 70% of your investment into fixed income and invest the difference in the asset yourself, chances are that you will make as much or more than the linked note. However, if you can’t stand fluctuation, you will probably choke after 6 months of bear market, sell everything and then, cry that you didn’t make money with the stock market. If it’s your case, then, the linked note is a really good investment for your portfolio. If you are able to take market fluctuations without losing your sleep, then, linked notes are totally useless.
Nothing is black or white in the world of investment…
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