Principal Protected Notes – fancy name, but what does it mean?

Previous bear markets and subsequent volatility has really made investors gun-shy about putting money into stock markets.  People are more concerned about “the return of their money rather than the return on their money” – quote courtesy of Will Rogers – American philosopher.  Not surprisingly, guaranteed investing is popular again.

A Principal protected Note (PPN) is an investment contract with a guaranteed rate of return of at least the amount invested, and a possible gain.  While tying the return to stocks or indexes has the potential to deliver substantial returns, they do so at much greater risk.  Throughout the unpredictable and volatile market conditions that characterised the late 1990s and early 2000s, investors increasingly sought out new approaches to investing that offered both security and potential growth. PPNs were introduced to the North American at that time.  They can be linked to a broad range of underlying investments. These investments often include indexes, mutual funds, baskets of mutual funds, baskets of equities and even alternative offerings such as hedge funds or derivatives.

PPNs are a more complicated and sophisticated form of index-linked GICs.  These notes are typically issued in a series, which means they have a limited availability.  Index-linked GICs are often issued on this basis as well.  When you purchase a note, your money will typically sit in cash until the subscription date.  At this time, the asset management company teams up with a bank to provide the note.  A Fund Management company typically handles the arrangements for the equity products or managed futures while the bank provides the guarantee of capital.

Typically, these notes have a term of 7 to 10 years to maturity. It is important to note that the guarantee of capital is only good if the note is held to maturity.  The key is that these products provide a guaranteed return of capital with the potential for higher returns by linking the performance to equity-type instruments.

While the sound good – “protected” is a powerful word, there are risks to the investors.  If the worst-case scenario occurs, you will get your money back but you will have lost the opportunity to do something else with your money for that 7-to-10-year period. It is therefore very important that you really understand the risks that are inherent in the investment strategies of the underlying link.

A key difference between PPNs versus an index-linked GIC is that you have some liquidity. Once you buy an index linked GIC you are stuck to maturity.  With a PPN there is at least come possibility you can sell them before the maturity date.  However, READ the fine print.  How much can you take out, for what reasons, how often and at what cost?  It is critical to consider your need for liquidity before buying these types of products.  Some PPNs allow for partial redemption but there is no secondary market.  Sometimes, the bank will purchase the note but there are no guarantees.

Next, how good is the guarantee of capital repayment? When you buy a GIC, you consider the security of the issuing institution and its ability to pay you back your capital but virtually all GICs are protected through either the CDIC or the CUDIC.  With PPNs there is no insurance.  You must be satisfied that the bank providing the guarantee is solid and secure.

PPNs may offer an array of benefits.
•    100% principal protection
•    high growth potential
•    enhanced income potential
•    the opportunity to participate in a broad range of investments
•    potential for leveraged returns
•    capital protection regardless of what happens in the markets

Like everything else, there are some disadvantages too.
•    opaque fee structure based on variables over the term of the investment
•    payment only at maturity
•    underlying investments that the average investor has no hope of understanding
•    no prospectus, very limited information regarding the full details of the underlying investment
•    custom design causes difficulty in evaluating one vs. another or against more conventional investments
•    lack of data showing how this type of investment has performed historically
•    possibility of failure of underlying investments

With credit to Wikipedia® for some of the information contained in this article.

James Dean

James Dean - President ~ Money Canada Limited (MONEY.CA)