The Basics of Deposit Notes

Between 2009 and 2014, the deposit note market grew considerably in Canada. These notes are mainly issued by Canadian banks, which represent the vast majority of issues during this period. These products can be grouped into two main families: protected notes and notes with capital risk.

Principal protected notes

are guaranteed by the issuer in the same way as a bond issued by the same company. Although they are often compared to equity GICs, they are not guaranteed by the CDIC (Canada Deposit Insurance Corporation), but the principal and interest are guaranteed at maturity by the issuer as specified in the subscription documents.

Principal at risk notes

generally offer partial principal protection with the potential for higher gains than a comparable principal protected note. Usually, the greater the protection on a note, the less earnings potential it will have and vice versa. Principal at risk notes may also offer tax benefits.

Two factors explain the popularity of the deposit notes:

  1. Deposit notes provide a portfolio risk adjustment while gaining exposure to a market. For example, an investor may seek exposure to a market like Europe while benefitting from partial protection of their capital at maturity.
  2. Low interest rates have also contributed significantly to the growth of the deposit note market, especially principal at risk structures, because they offer high distributions which can be tax efficient.

Integrated with a diversified portfolio, deposit notes may be suitable for all investors. For example, the prudent investor can increase their potential return while maintaining safety of capital. A retired person may prefer a product that pays regular,tax efficient distributions. An investor with growth as an objective could choose an accelerator note that allows them to boost the performance of the reference index or opt for a protective barrier that allows them to mitigate downside risk. These examples illustrate how deposit notes differ from traditional investments such as mutual funds and exchange traded funds.

Most notes require a minimum initial investmentwhich can vary by issuer. They can be held in non-registered accounts as well as registered accounts. The performance of deposit notes is based on an underlying asset such as a stock index, an exchange-traded fund, the price of a basket of natural resources, etc. At maturity, the holder of a note receives an amount equal to the nominal value of their investment plus the variable return of the note (which could be negative in the case of principal at risk notes). It is important to note that in most cases,principal protection and protection barriers are only effective at maturity. An investor should always consider the possibility of having to hold their investment in a deposit note until maturity.

In most cases, deposit notes may be sold prior to maturity on the secondary market* at fair market value as determined by the issuer. The investor will make a profit if the sale price exceeds the purchase price and a loss if the sale price is lower than the purchase price.

Wide Variety of Products Available

There is a wide variety of notes available on the market today, allowing each investor to find a suitable matchfor their profile. The most common are the notes that replicate the performance of a stock market of a country or region. For example, the performance of a "Canadian Blue Chip" index note will be linked to the performance of the Canadian S&P/TSX 60 index, while that of a Eurostoxx50 index note will track the European index. There are also notes for investing in a specific sector such as commodities. Other notes are structured around the movement of interest rates.

As you can see, deposit notes may be an attractive product to diversify one's portfolio, increase potential yield while adjusting the risk level of one's investments.

The first rule to follow before proceeding with the purchase of notes is to become informed of the main characteristics ofthis product by reading the information statement.

* The secondary market for this type of product may be restricted. This information does not represent a recommendation of investment. Capital is only guaranteed if the investor holds until maturity. The market is maintained by the issuer and your capital is not guaranteed. Deposit notes are not conventional notes or debt securities. Notes will not constitute deposits insured under the Act respecting the Canada Deposit Insurance Corporation or any other deposit insurance regime. Deposit notes do not provide investors with a return or a regular income stream prior to maturity, calculated using an interest rate. There is no assurance that notes will generate positive returns or that the fund will succeed in achieving its objectives. You should consult the information statement before investing, specifically the section mentioning the risk factors.

The author

Sébastien  Hébert

Sébastien Hébert

CFA, Senior Analyst - Structured Products
Sébastien Hébert began his career with Desjardins in 2001 and held several positions in the organization until 2008. He subsequently advanced in Compliance at National Bank working with derivatives, private placements, new products and hedge funds. In 2013, he returned to the Desjardins Group and has since held the position of Senior Analyst, Structured Products with the Portfolio Management Group. Sébastien holds a CFA charter as well as a finance degree from the Université du Québec in Montreal. He has over twelve years of experience in financial services, particularly in the investment sector, derivatives, compliance and currency exchange hedging.