Index-linked notes

The secular decline in interest rates since the early 1980’s has led to the current low yields for present GIC holders. Currently, one-year T-Bills are yielding approximately 3.90%. In Canada, inflation is expected to annualize at 2.1% for 1997. Combine this with current maximum marginal tax rates on GICs (50%) and the resulting real return is less than one percent per annum.

Under these conditions, investment alternatives providing a guaranteed return of capital are attractive. One such alternative is Index-linked notes. Index-linked notes provide a guaranteed return of capital at expiry and offer potential upside equal to the advance or decline of the underlying stock market index.

The notes are structured such that, upon maturity, investors receive their original capital, plus a variable return based on a change in the underlying index. For example, if an underlying stock market index were to rise 20% between the issue date and the maturity date of the note, investors with an unleveraged index-linked note would realize a 20% gain. On the downside, the worst possible scenario would result in the return of the original capital invested, without further penalty.

Indeinked notes offer a series of features that are particularly attractive in the current investment environment. First, investors may elect to receive interest on any portion of the principal invested (generally in multiples of $1000) prior to maturity. Second, payments are in Canadian dollars and therefore investors have no direct foreign-currency exposure, even if the underlying index is foreign. Benefits of this feature would invariably include global diversification (see Tip #17, The Benefits of Global Diversification). Third, index-linked notes are RRSP eligible, and are generally considered as Canadian content. And finally, variable returns are quite frequently leveraged. For example, a 20% increase in a stock market index with a leverage factor of 125% provides a 25% gain upon maturity.

Merrill Lynch’s Investment Strategy Committee’s outlook on Canadian equities remains optimistic with a 7800 twelve month target on the TSE 300. For a comprehensive review of Index-linked notes, please contact your Merrill Lynch Financial Advisor and request a copy of the “Index-Linked Notes and Related Product Update” report.

The information contained in this report was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. Merrill Lynch Canada Inc. is not a tax advisor and we recommend that clients seek independent advice on tax related matters.

Financial Tips courtesy of Merrill Lynch Canada Inc.