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What are equity-linked notes and how do they work?

This is one of those exotic investment products that isn't widely known. It's kind of like an equity linked GIC, although not all of them have a guarantee on your original investment.

In the language of the industry, they're called equity linked notes. The issuer of these notes is borrowing your money, which makes this investment a debt obligation. You receive a return that's tied to the performance of a particular stock index or equity mutual fund. Some give you a return based strictly on how well the stock index or equity fund does. Others tie your return to the stock index or equity mutual fund, but also guarantee at least your original investment if you hang onto the notes until they come due or mature. This maturity date may be 10 years down the road. This type of product can be complex. Toronto Dominion Bank/Templeton International Stock Fund Linked Notes are an example of equity linked notes that do not offer a guarantee on your capital. Their main attribute is that it gives you a way to increase your international exposure in an RRSP without being restricted to the 30% foreign content limit. The notes don't count as foreign content in registered plans. The investment objective of the underlying equity mutual fund -- in this case Templeton International Stock Fund -- is to earn capital gains, interest and dividend returns by investing in the securities of companies and governments outside Canada and the U.S. However, the gains for those investors who hold notes linked to this mutual fund are treated as interest income. Interest income is taxed at the highest personal income tax rate. Mutual funds charge management and other expenses reflected in a management expense ratio that reduces the net return paid to the fund's investors. Investors in a product linked to that net return such as equity linked notes are effectively paying that charge too. Issuers of equity linked notes add on their own management expense ratio. Therefore, holding equity linked notes outside an RRSP where foreign content restrictions don't apply makes little sense. You could instead invest directly in the foreign equity mutual fund and pay one set of management expenses, rather than two. The TD notes are debt issued by the TD Bank. They are to mature April 15, 2009. The final closing date to buy these securities is scheduled for April 15, 1999. It's anticipated that interest will be paid on these notes once a year. This amount, if any, would equal the distribution paid on the underlying mutual fund, less the management expense ratio paid to TD of 0.60% per year of the average daily net asset value of the mutual fund. The interest payment, less the 0.60% charge, would be reinvested in additional notes on behalf of investors, rather than being paid out as cash. The issue price of the TD notes is $100, with a minimum purchase of $2,500. For every $100 you invest, $99 actually ends up being invested because 1% is paid to the underwriters of the issue. If you redeem the notes within six years, a redemption fee, which declines over time, will be charged. If you redeem before April 15, 2000, the fee is 6% of the note's original value. You would be paid an amount equal to the current market value of the mutual fund's net asset value per share, less the redemption charge, and less TD's management expense ratio. Unlike a mutual fund bought with a back-end load or deferred sales charge, there's no right to an annual free redemption of 10% of the notes. If you hold the notes to maturity, you would receive an amount equal to the mutual fund's net asset value per share at that time, less the bank's management expense ratio. This example is offered for educational purposes only. investorlearning.ca does not recommend specific investment products. Make sure you fully understand any investment product before investing. Check the prospectus to determine whether it may meet your needs. Consider seeking professional investment advice.