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Structured Products Explained: Are You Overpaying for That Guarantee? | Canadian Investing · How Canadian Markets Work

• 0:00
  You know, just as we discovered how REITs and
• 0:02
  income trusts quietly create this massive tax
• 0:07
  bill years later through return of capital, today
• 0:10
  we are exposing another really beloved financial
• 0:12
  product where the label on the wrapper hides
• 0:15
  a pretty surprising reality. Oh, definitely.
• 0:17
  a very surprising reality. Right. I mean, imagine
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  walking into a car dealership. You pay full sticker
• 0:23
  price for a Ferrari and you drive it off the
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  lot only to realize they swapped the V8 engine
• 0:29
  for a lawnmower motor. Yeah, that's that's a
• 0:31
  painfully accurate comparison. It is. And today
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  we're looking at the financial equivalent of
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  that exact trade. We are putting principal protected
• 0:39
  notes and market linked GICs under the microscope
• 0:42
  for this deep dive. Which is huge because those
• 0:45
  are phrases that sell an absolute mountain of
• 0:47
  product exactly because they sound like the ultimate
• 0:50
  financial holy grail you know upside without
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  downside it's an incredibly seductive pitch i
• 0:55
  mean the marketing taps into two of our most
• 0:57
  primal financial instincts at the exact same
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  time basically yeah on one hand you get the thrill
• 1:03
  of the upside potential of the stock market and
• 1:05
  on the other hand there's this uh this safety
• 1:09
  net stitched underneath every single dollar of
• 1:12
  your principal. Which is what everybody wants.
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  We inherently want our life savings to be safe.
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  Right, but nobody wants the FOMO of missing out
• 1:19
  on a roaring bull market. So when a product comes
• 1:21
  along offering both, I mean, people just line
• 1:23
  up to buy it. But then you actually open up the
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  hood of these products and suddenly that comforting
• 1:27
  feeling starts to evaporate. Very quickly. Yeah,
• 1:31
  we're looking at a structural landscape today
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  that is quite honestly an illusion built on extremely
• 1:36
  rigid arithmetic so our mission for this deep
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  dive is to take a stack of sources on these structured
• 1:42
  products and Basically deconstruct exactly how
• 1:45
  they're built piece by piece It's a fascinating
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  deconstruction too because the mechanics behind
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  these products are totally obscured from the
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  retail buyer Completely hidden right the person
• 1:55
  buying it thinks they're getting a magical shield
• 1:58
  but the person designing the product, they're
• 2:01
  just balancing a very strict budget using standard
• 2:03
  financial tools. Just arithmetic. And I want
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  to assure you listening right now, by the end
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  of this deep dive, you will be able to evaluate
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  every single product in this category in under
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  two minutes. Two minutes tops. Yep. You are going
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  to save yourself from locking up your money blindly
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  just because a glossy brochure has the word protected
• 2:22
  printed in bold font. But before we completely
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  tear this product apart to look at the math,
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  we first need to look at the label itself. Always
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  step one. Because we have to understand who exactly
• 2:33
  is promising to protect your money. Yeah, we
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  really need to define what a structured product
• 2:38
  actually is before we even look at the protection.
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  Okay, let's unpack this. At its core, it's simply
• 2:44
  a debt instrument, meaning a bond combined with
• 2:47
  a derivative. And it's all packaged together
• 2:50
  in a nice wrapper and sold to retail investors.
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  But the wrapper matters, right? It matters immensely.
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  Yeah. If we look at the big picture, a deposit
• 2:58
  insured product and an issuer obligation. are
• 3:01
  genuinely different things, even though they
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  wear very similar language. So if I go into my
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  local branch, I usually see market -linked GICs
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  and principal protected notes sitting on the
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  exact same desk, pitched by the exact same advisor.
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  Are they the same thing? Not at all. A market
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  -linked GIC issued by a bank is often eligible
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  for deposit insurance, you know, like CDIC. Meaning
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  a government -backed entity is insuring the principal
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  up to a limit. Exactly. A principal protected
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  note, however, generally does not have that backing.
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  It is simply an obligation of the issuer. It's
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  essentially a corporate IOU. Wait, I have to
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  push back on the industry's use of the term protected
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  here. If a note is just an issuer obligation,
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  doesn't that mean the protection is only as good
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  as the bank's credit? That is the reality of
• 3:49
  unsecured debt. Yes. So if the issuing institution
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  fails, I don't have a magical shield. I'm just
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  a creditor standing in line in bankruptcy court
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  hoping to get paid out of whatever is left right.
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  Right. The word protected implies this universal
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  ironclad law of nature to the average person.
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  But legally. Legally, it is just a contractual
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  promise from a specific corporation. Which is
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  wild when you think about it. Well, is the likelihood
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  of a major national bank defaulting low? Yes,
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  historically it's very low. But the risk is definitively
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  not zero. You are taking on the credit risk of
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  that specific issuing institution. So if they
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  run into severe financial trouble, that guarantee
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  is suddenly worth exactly what their credit is
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  worth. Which could be pennies on the dollar.
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  That is a massive distinction to make right out
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  of the gate. You're trading away your potential
• 4:38
  market returns for a guarantee, so you better
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  be absolutely certain the entity making the guarantee
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  can actually write the check in a severe financial
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  crisis. Exactly. But let's move past the label
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  and get into the actual machinery here. Now that
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  we know this protection is just a promise from
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  an issuer, how exactly do they manufacture this
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  guarantee with your money? Let's do the math.
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  This is where the engine swap analogy really
• 5:00
  comes to life. Let's build one of these from
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  scratch. Okay, we'll deconstruct a standard five
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  -year note. Okay, already. So you walk into the
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  bank and hand over $100. The brochure promises
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  your $100 back at maturity in five years, plus
• 5:15
  participation in, say, the S &P 500. Sounds great
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  so far. Right. But the bank doesn't just put
• 5:20
  your $100 in a vault and hope for the best. To
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  guarantee that $100 comes back to you in five
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  years, the issuer takes a large chunk of your
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  money right now and buys a zero -coupon bond.
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  I want to pause here just to make sure we're
• 5:33
  all on the same page. A zero coupon bond doesn't
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  pay regular interest like a normal bond, right?
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  No, not at all. It's issued at a deep discount,
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  and it slowly grows back to its full face value
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  at maturity. So if I buy a bond for, say, $80
• 5:47
  today, it matures at $100 in five years. Exactly
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  right. So the critical question for the product
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  designer is, how much does that zero coupon bond
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  cost? Because that dictates everything else.
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  It dictates everything. And it depends entirely
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  on current interest rates. So let's assume five
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  -year interest rates are sitting at 4%. To ensure
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  they have $100 to give back to you in five years,
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  the issuer has to spend roughly $82 .19 today.
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  Let me just do the mental math on that. Out of
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  my $100 investment, $82 .19 is immediately siphoned
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  off just to buy the bond that funds the guarantee.
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  Right. It's locked away. It's not going anywhere
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  near the stock market. No, it is entirely locked
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  in fixed income. That leaves the issuer with
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  $17 .81 of your original hundred. OK. But they
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  aren't building, marketing, and distributing
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  this product out of the goodness of their hearts.
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  There are fees. Obviously. Let's subtract roughly
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  $4 in embedded fees, which cover the internal
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  structuring, the marketing brochures, the dealer's
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  commission. Which leaves us with exactly $13
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  .81. Right. That $13 .81, which is under 14 %
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  of your original capital, is all that is left
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  to buy market exposure. Under 13%. Wow. Yeah.
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  And they get that exposure by purchasing a five
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  -year call option on the market index. OK. For
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  anyone who gets hives when they hear the word
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  derivative, let's demystify what a call option
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  is in this context. It's basically a side bet
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  or like a reservation ticket, right? It's a good
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  way to look at it. You pay a small premium today
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  for the right to capture the upside of the market
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  later. If the market goes up, your ticket pays
• 7:27
  out. If the market crashes, your ticket becomes
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  worthless. But you only lost the small premium
• 7:34
  you paid. That is a perfect explanation. The
• 7:37
  call option is the engine that drives your market
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  return. But remember the budget. Right, the 13
• 7:42
  bucks. The designer only has $13 .81 to buy that
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  option. That tiny budget. perfectly explains
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  why these products have such strict limits on
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  your potential returns. Because $13 cannot possibly
• 7:55
  buy full exposure to $100 worth of the stock
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  market. It mathematically cannot. The budget
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  forces the designer to cap your participation.
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  So the product might state that you only get
• 8:07
  60 % of the index's return, or maybe your total
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  return is capped at a hard ceiling of 30 % over
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  the five years. You know, when investors see
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  those caps, they often think the bank is just
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  being greedy and keeping the rest of the profits.
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  What's fascinating here is the cap isn't the
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  issuer being stingy. It's just rigid arithmetic.
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  The budget only allowed for a partial option.
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  Here's where it gets really interesting, honestly.
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  Buying a structured product is basically like
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  buying a combo meal at a fast food joint. And
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  when you open the box, you discover 86 % of the
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  price was just the bun, and only 14 % is the
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  actual meat. Yeah, that's exactly it. You aren't
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  investing $100 in the stock market. You are putting
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  $82 in a locked savings account, paying a $4
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  cover charge, and taking a $14 trip to the casino
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  with the leftover interest. When you break it
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  down like that, the illusion of upside without
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  downside. totally shatters. You only sent $14
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  to the market, so you only get $14 worth of upside.
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  Which leads me to a really critical realization
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  here. If this entire product relies on the leftover
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  budget after buying that zero coupon bond, what
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  happens when bond prices change? Because interest
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  rates dictate the price of that bond, which means
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  interest rates must completely dictate the quality
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  of the structured product. They absolutely do.
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  There is an elegant but ruthless dependency on
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  interest rates here. It operates exactly like
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  a seesaw. How so? Well, let's look at a high
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  rate environment first. If interest rates are
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  high, say five or six percent, that zero coupon
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  bond costs much less today. It might only cost
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  seventy five dollars to grow to one hundred in
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  five years. leaving a much larger budget like
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  twenty five dollars for the option. Exactly.
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  And with twenty five dollars, the designer can
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  buy a much better call option, which means they
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  can offer the investor a higher participation
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  rate, maybe 80 or 90 percent of the market upside.
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  OK, but let's look at the other side of the seesaw.
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  We all lived through the 2010s, you know, a decade
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  of near zero interest rates. If five year rates
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  are sitting at, say, one percent, what happens?
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  Well, one percent that zero coupon bond costs
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  nearly ninety five dollars today. Oh, wow. So
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  out of my $100, $95 goes to the bond. Subtract
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  the $4 in fees, and the designer has exactly
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  $1 left to buy the call option. The engine is
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  entirely starved of fuel. At very low interest
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  rates, the bond consumes almost all of your initial
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  capital. Just to guarantee the principal. Exactly.
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  And this creates a massive behavioral trap for
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  the retail investor. During those low -rate years,
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  the budgets for these options were basically
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  nonexistent. The participation caps became incredibly
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  meager. Like what kind of caps are we talking
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  about? We saw products offering perhaps 20 or
• 10:55
  30 percent participation in the index, or strict
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  total return caps of 10 percent over five years.
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  Yet investors still bought them in droves. Because
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  the phrase principle protected sounds identical
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  to the consumer regardless of what the underlying
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  math is doing, the marketing glosses right over
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  the fact that the product is mathematically starved.
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  Let me make sure I'm understanding the real -world
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  impact of this in a low -rate environment our
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  investors essentially locking up their money
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  for five years just to get a microscopic sliver
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  of upside Completely starving themselves of real
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  returns. Yeah, they're paying a massive invisible
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  premium for a psychological floor In a low -rate
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  environment, the cost of that guarantee is astronomical
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  in terms of opportunity cost. Because you're
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  making almost nothing. You're voluntarily entering
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  an environment where your money cannot grow meaningfully.
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  Meanwhile, you're fully exposed to inflation
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  risk. If inflation is 3 % a year, and your money
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  is locked up making zero or 1%. Your actual purchasing
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  power is being destroyed. Exactly. All for the
• 11:57
  comfort of knowing your nominal principle is
• 11:59
  technically intact. Okay, let's pull this Frankenstein
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  product out of the theoretical math and put it
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  into the real world. I wonder how this actually
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  performs for the investor compared to just holding
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  a standard index fund. Let's run a few what -if
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  scenarios. Let's do it. Let's assume a 60 % participation
• 12:16
  rate for the note. And let's start with the scenario
• 12:18
  the brochure really wants you to focus on. Right.
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  Let's say 2008 happens all over again. The market
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  crashes and the index falls 30 percent over those
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  five years. In this crash scenario, the note
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  does exactly what it promised. The option expires
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  worthless, but your zero coupon bond matures
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  at par. You get your full one hundred dollars
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  back. OK. Your neighbor with the index fund sees
• 12:43
  their investment drop to seventy dollars. The
• 12:45
  structured note wins by $30. And let's be totally
• 12:48
  honest, this is the exact scenario the product
• 12:51
  is exclusively sold on. It preys on that very
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  real fear of loss. Absolutely. But let's look
• 12:56
  at a different reality. What if the market doesn't
• 12:58
  crash, but it doesn't boom either? What if it's
• 13:01
  just a boring, flat market and we end exactly
• 13:04
  where we started five years later? This is where
• 13:06
  the hidden costs truly reveal themselves. In
• 13:09
  a flat market, the note returns your $100. The
• 13:12
  index fund also finishes at $100. So it's a tie.
• 13:15
  On paper, it looks like a tie. But it is not
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  a tie. The index fund investor gets their $100,
• 13:22
  plus five years of accumulated dividends from
• 13:24
  all the companies in that index. Wait, the note
• 13:27
  investor gets zero dividends. Zero. Structured
• 13:30
  products typically track the price return of
• 13:33
  an index only. They entirely ignore the total
• 13:36
  return, which includes dividends. I need to pause
• 13:39
  on this because giving up dividends is huge.
• 13:42
  You are paying for this free downside protection
• 13:44
  by completely surrendering five years of dividend
• 13:48
  income. Even if the market just goes sideways,
• 13:51
  you are losing out on a massive driver of compound
• 13:54
  growth. Dividends historically make up a very
• 13:56
  significant portion of total equity returns.
• 13:59
  Giving them up is an enormous structural cost
• 14:01
  that is rarely highlighted in the pitch. I bet.
• 14:04
  And the math gets even more frustrating for the
• 14:06
  investor if the market actually does well. Let's
• 14:08
  run that scenario. Let's say we hit a roaring
• 14:10
  bull market. The index rises 50 % over the five
• 14:14
  years. with the index fund, sees their $100 grow
• 14:19
  to $150, and they collect five years of dividends
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  on top of that. Nice. You, holding the structured
• 14:26
  note with a 60 % participation rate, get 60 %
• 14:29
  of that 50 % gain. So you walk away with $130,
• 14:33
  and again, zero dividends. You're leaving a staggering
• 14:36
  amount of money on the table. The takeaway here
• 14:38
  is that every product in this category is simply
• 14:41
  a trade. You are trading away your dividends
• 14:44
  and a large chunk of your upside to buy a floor.
• 14:47
  So what does this all mean for the listener?
• 14:49
  Basically, you are paying for this free protection
• 14:51
  by surrendering five years of dividend income,
• 14:54
  even if the market does well. The protection
• 14:56
  is never free. You pay for it in foregone income
• 14:59
  and capped growth. OK, so I'm giving up my dividends
• 15:02
  and I'm giving up a huge chunk of my upside.
• 15:05
  The only justification for paying that massive
• 15:07
  invisible price is if this downside floor is
• 15:10
  made of pure concrete. Is it? Let's check the
• 15:13
  fine print. The fine print is where things get
• 15:16
  truly precarious. Many investors assume protection
• 15:20
  means a hard stop at zero loss across the board.
• 15:22
  Right. But you have to watch out for terms like
• 15:25
  buffers or barriers. In many products, the structure
• 15:29
  is only partially protected. For example, a note
• 15:33
  might have a barrier that protects you against
• 15:35
  the first 20 % of market declines. OK, so if
• 15:38
  the market drops 15%, I get my $100 back. But
• 15:41
  what if it drops 25 %? If the index falls beyond
• 15:44
  that specific threshold, if it drops 25%, the
• 15:47
  protection often vanishes entirely. It's referred
• 15:50
  to as a knockout barrier. It vanishes entirely,
• 15:52
  like a trapdoor. I don't just lose the 5 % difference.
• 15:54
  In many structures, exactly like a trapdoor.
• 15:57
  If the barrier is breached, you take the full
• 15:59
  25 % loss, as if the protection never existed
• 16:02
  at all. That is maddening. It's a trapdoor that
• 16:05
  opens in the exact scenario you bought the protection
• 16:07
  for. You buy this thing because you are terrified
• 16:10
  of a 30 % market crash, and then the fine print
• 16:13
  says, oh, if it actually drops 30%, we disconnect
• 16:16
  the parachute. Pretty much. Why on earth is it
• 16:19
  built like that? This raises an important question,
• 16:23
  and it connects back to a broader theme in our
• 16:26
  sources. Protections tend to weaken under the
• 16:29
  exact conditions that make you want them. But
• 16:31
  mathematically, why? It goes right back to the
• 16:33
  budget we discussed earlier. Remember that $13
• 16:36
  .81, buying a call option that provides full,
• 16:40
  unconditional downside protection is very expensive
• 16:43
  on the institutional market. Oh, I see. But if
• 16:46
  the bank buys an option with a knockout barrier,
• 16:49
  The seller of that option takes on less risk,
• 16:52
  so the option is much cheaper to buy. Adding
• 16:54
  that trapdoor is often a mathematical necessity
• 16:57
  just to make the option fit into your tiny lift
• 17:00
  over budget. Unbelievable. It always comes back
• 17:02
  to the arithmetic. Always. What about getting
• 17:04
  your money out early? Let's say I have a financial
• 17:06
  emergency in year three of this five -year note,
• 17:09
  a medical issue, a job loss, whatever. Can I
• 17:12
  just sell it back to the bank and get my guaranteed
• 17:14
  principal? No, you generally cannot. These products
• 17:18
  usually have very poor secondary liquidity. The
• 17:21
  principal guarantee applies exclusively at maturity.
• 17:24
  It is a promise to pay you $100 on a very specific
• 17:28
  date five years from now. Not a day sooner. Right.
• 17:32
  If you need to sell early, you must sell it on
• 17:34
  the secondary market and you take whatever price
• 17:36
  the market offers you that day. And that price
• 17:39
  is going to be heavily discounted. The dealer's
• 17:41
  going to take a spread. And if interest rates
• 17:43
  have gone up since you bought it, the underlying
• 17:45
  zero coupon bond is worth less. I want to draw
• 17:49
  a parallel here for you listening, because this
• 17:51
  is exactly like the segregated funds we've talked
• 17:53
  about before. Yes, very similar. The guarantee
• 17:55
  only works on a date you don't get to choose.
• 17:57
  If life happens and you need your money early,
• 18:00
  the guarantee is an illusion. You are totally
• 18:02
  exposed to market pricing. That is the core of
• 18:05
  the liquidity illusion. The safety exists only
• 18:08
  if your personal life timeline perfectly matches
• 18:11
  the product's rigid maturity timeline. If those
• 18:15
  timelines diverge for any reason, the safety
• 18:17
  net dissolves. So if we pull all of this together,
• 18:21
  we have a product where the vast majority of
• 18:24
  your money is just locked in a bond. You pay
• 18:27
  steep embedded fees. You surrender all of your
• 18:29
  dividend income. Your upside is brutally capped
• 18:32
  by a tiny option budget. Don't forget the trap
• 18:35
  doors. Right. The downside protection might have
• 18:36
  a literal trap door in it and you can't touch
• 18:39
  the money early without taking a haircut. When
• 18:41
  you lay it out sequentially like that, it certainly
• 18:43
  sounds dire. But I always remind people that
• 18:46
  the underlying mechanics, the zero coupon bond
• 18:48
  and the call option, they're just neutral financial
• 18:51
  tools. They aren't inherently evil. Just used
• 18:53
  in a tricky way. The issue is the massive asymmetry
• 18:56
  of information between the institution designing
• 18:59
  the product and the retail investor buying it.
• 19:02
  It is the ultimate triumph of marketing over
• 19:04
  math. But that is exactly why we do these deep
• 19:07
  dives. We want to empower you with a new toolkit
• 19:10
  to see through the glossy wrapper. You now know
• 19:13
  that a structured product is never a magic trick.
• 19:16
  It's just a bond funding a guarantee with the
• 19:19
  leftover pennies buying a capped call option.
• 19:21
  Your checklist going forward should be immediate.
• 19:24
  First, always check who is actually guaranteeing
• 19:27
  the product. Is it deposit insured or is it an
• 19:31
  unsecured corporate obligation? Crucial first
• 19:33
  step. Second, Check the maturity timeline and
• 19:36
  ensure you can absolutely lock that money away
• 19:39
  for the full term because an early exit nullifies
• 19:42
  the guarantee. And finally, do the two minutes
• 19:45
  of arithmetic. Look at current interest rates,
• 19:47
  figure out what the underlying bond actually
• 19:50
  costs, and realize exactly how little of your
• 19:52
  capital is going to work in the market. Once
• 19:54
  you see that 14 % meet and 86 % bun, the mystery
• 19:58
  disappears entirely. It really does. It shifts
• 20:01
  you from being a passive consumer of financial
• 20:03
  marketing to an active evaluator of risk and
• 20:06
  return. Yeah. And ultimately, that is the only
• 20:08
  way to navigate these markets safely. Exactly.
• 20:11
  Which brings me to a final sort of provocative
• 20:13
  thought for you to mull over as we wrap up today's
• 20:15
  deck. we established that these structured notes
• 20:17
  only track the price return of an index, meaning
• 20:19
  you completely forego five years of dividends.
• 20:22
  Yep, five years. But think about this. The underlying
• 20:25
  companies in that index, you know, the banks,
• 20:27
  the telecoms, the utility companies, they are
• 20:30
  still paying those dividends out in the real
• 20:32
  world every single quarter. If you aren't getting
• 20:35
  them while your money is locked up in this product,
• 20:38
  who exactly on the other side of this structured
• 20:40
  trade is quietly pocketing all that yield? Now,
• 20:43
  that is a structural question. worth asking the
• 20:45
  next time someone hands you a brochure promising
• 20:48
  safety. Upside without downside, right? Just
• 20:50
  remember to check the wrapper, then do the math.