Personal Finance

They may end up being a zero-interest loan to the issuer.
By Andrew Hepburn | 14/10/16

For most people, an ideal investment is one with no downside but the chance of a significant gain. On the surface, principal-protected notes (PPNs) -- debt instruments offered by banks and other financial institutions -- might seem to be a dream come true for investors. But are they?

About the Author
Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, RateHub.ca and Canadian MoneySaver.

There are two main components of PPNs. First, they offer a guarantee that an investor's money will be fully repaid when the note matures. In this regard, PPNs are similar to guaranteed investment certificates (GICs).

However, unlike GICs, PPNs do not generally offer fixed interest payments. Instead, the return on a PPN is linked to the future performance of a specified asset. That asset could be a stock index, a commodity, a currency or a basket of stocks.

For example, CIBC is currently offering a PPN tied to the performance of an equally weighted stock portfolio consisting of Bank of Nova Scotia, Emera, Fortis, Inter Pipeline, National Bank, Pembina Pipeline, Rogers Communications, Shaw Communications, TELUS and TD Bank. Denominated in U.S. dollars, this PPN promises a variable return equal to 115% of the average price gain of these stocks over a seven-year period. The variable return excludes corporate dividends.

Let's say the basket of stocks appreciates by 50% over the course of the seven-year term. An investor in CIBC Canadian Blue-Chip Growth Deposit Notes, Series 23 (USD) would receive a variable return on their principal of 57.5%. That's 115% of the 50% performance delivered by the 10 shares. So on an investment of $10,000, an individual would get the initial $10,000 back, plus $5,750 to account for the variable return. Especially in today's world of low interest rates, that would be a great return on a debt product.

However, while some PPNs do provide for a minimum return, many only promise a return of capital. That is to say, investors can end up getting nothing back other than their original investment.

Going back to the example of the CIBC PPN, imagine that at the end of the seven years the basket of stocks has a slightly negative return. It could be the result of one or more companies dramatically underperforming, or a prolonged bear market in general. Whatever the reason, a negative performance for the reference basket will mean that there is no variable return.

A zero return may not seem like the end of the world, but the consequences are not trivial. For one thing, there's an opportunity cost. Noteholders could have invested their money in something just as safe, but with a guaranteed return.

Perhaps the larger risk, especially with long-term PPNs, is the pernicious effect of inflation. If you give a bank $10,000 today and it returns $10,000 to you seven years from now, your purchasing power will have declined significantly. With consumer prices rising at a rate of about 2% annually these days, that's the minimum an investment must return just to keep pace with inflation.

There are other risks with PPNs. Most of them do not qualify as deposits, and therefore are not insured by Canada Deposit Insurance Corp. Should an issuing financial institution go bust, PPN holders would lose some or all of their investment.

PPN investors should also be aware of the impact of fees on returns. In fact, the Ontario Securities Commission has warned: "In addition to sales commissions and early redemption fees, PPNs may charge management fees, performance fees, structuring fees, operating fees, trailer fees and swap arrangement fees."

Tellingly, a 2010 review by the Investment Industry Regulatory Organization of Canada (IIROC) found insufficient disclosure of fees and expenses in marketing materials for PPNs issued by its member firms.

The issues surrounding early redemption, in particular, are something prospective PPN investors should understand. To illustrate this, consider a current offering, the TD Canadian Banks-Linked Growth Notes, Series 57.

According to TD's information document, noteholders who redeem within 45 days of the note's issuance will be charged a fee equal to 4% of their principal. But that's not all. TD warns in the "Risk Factors" part of the document that there is no guarantee of an active or liquid secondary market for the product. As the bank explains, this means "The Noteholder may have to sell the Notes at a substantial discount from the original Principal Amount and the Noteholder may as a result suffer a substantial loss."

Investments that are both complex and illiquid are not appropriate for most investors. Principal-protected notes, unfortunately, tick both of these boxes. Understanding how they work requires both a good deal of investment knowledge plus careful reading of the offering document. And while it's easy to buy them, selling them before maturity is a different matter altogether. At first glance, PPNs look great. But upon closer inspection, they're not a dream investment after all.

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