Understanding Principal Protected Notes

In recent articles, I have provided some different opinions on the world markets and whether they will continue their recent upward trend. While the jury may be out, there are certainly opportunities to make money in the markets based on the simple fact that everything goes in cycles.

However, the last bear market has really made investors gun-shy about putting money into highly volatile investments like the stock markets. Investors have become more concerned about the return OF their capital rather than the return ON their capital (or lack there of). As a result, guaranteed investing has become trendy once again. Principal Protected Notes are an innovative form of guaranteed investing which have become increasingly popular.

What is a Principal Protected Note?

Principal Protected Notes are structured investments that provide the benefit of guaranteed capital like GICs with the upside potential of equities, stock markets or commodities. Often these notes will utilize the use of derivative strategies.

In essence, the Principle Protected Note is a little more complicated and sophisticated form of the index linked GIC.

How do Principal Protected Notes work?

Essentially, these notes are typically issued in series, which means they have a limit on their subscription date. For example, Paradigm Asset Management currently has a note (Series III) that will be offered until September 30th or earlier if it is fully subscribed. 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. The asset management company typically manages the potential returns through equity products or managed futures while the bank provides the guarantee of capital.

Most of these notes will have a term of 7 to 10 year maturity. There are some new issues that are offering shorter-term notes like 3 or 5 years. It is important to note that the guarantee of capital is only good if the note is held to maturity.

Some of the mutual fund companies like Templeton, Mackenzie, Trimark, AGF and CI have come out with versions of the protected notes where they link the performance to some of their selected mutual funds. Other companies are creating links to hedge products as opposed to mainstream mutual funds.

Whatever the case, the key is that these products provide a guarantee of capital with the potential for higher returns by linking the performance to equity type instruments.

What are the risks of Principal Protected Notes?

According to Jeff Plate, manager of investment research for Manulife Securities, there are three major risks to the investor.

  1. Opportunity risk. Although there is not risk of capital loss, 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. According to Jeff, “you should really watch the investment strategies of the underlying link. While risky investments like managed futures have their appeal, there is an increased possibility of having a broken link. With a broken link, you will get your money back but the investor will have a slim chance of making money.”
  2. Redemption / Liquidity Risk. One of the key differences of these protected notes compared to an index GIC is that you have some liquidity. Once you buy an index linked GIC you are stuck to maturity. With a protected note, there are some provisions to sell before the end of the term. However, investors need to read the fine print. How much can you take out in case of emergencies and how often. It is very important for investors to consider their liquidity needs before they jump into these protected note products, Jeff adds, “Although many protected note products allow for partial redemption, there is no secondary market for these notes. Often the bank will purchase the note in case of redemptions but there are no real guarantees.
  3. Counter Party Risk. How good is the guarantee of capital? When you buy a GIC, you must consider the security of the bank and its ability to pay you back your capital but in the end insolvency is protected through CDIC. With protected notes, there is no insurance. Thus, you must make sure that the bank providing the guarantee is solid and stable. They are the ones backing the guarantee of capital. Some notes may be covered by CDIC.

My two cents

I think these protected notes have a lot of merit. You still need to be somewhat comfortable with the underlying investments but the guarantee provides that extra little piece of mind. Like anything, do your homework before you buy and make sure you read the fine print. Buy these products for their substance and not the sizzle.

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