Build Your Own Principal Protected Notes

*An intermediate level topic today.

Principal Protected Notes have many critics – mostly because of the fees and all the clauses that seem to favour the issuer as opposed to the investor. For those who are not familiar with Principal Protected Notes (PPNs), essentially they are investments that will guarantee your principal investment for a set number of years, while at the same time allowing for the participation in the gains of riskier investments (if they make money).

So on the surface, it would seem that you are getting the best of both worlds. You are guaranteed not to lose money as long as you hold your investment for a set period of time (normally around 5-7 years), and if the “linked” investment (like the broad Canadian index, or a foreign market index, etc.) makes money, then you make money too.

There are many tradeoffs however. A GIC would outperform the PPN if the markets go down since all that is guaranteed is your original investment. Often, if the linked market goes up too much, there is a clause that allows the issuer to collapse the structure and only give you a fraction of the gains you could otherwise have earned. The “linked” markets generally have very little chance of losing money over any 7 year rolling period, so you might be paying for nothing. On top of all of that, there are the fees.

Nonetheless, PPNs sell like hot cakes because they can look attractive to novice (or jittery) investors.

You can create your own PPN by doing the following: For every $1 you want to invest you could find a Government of Canada AAA strip bond for 89 cents that matures at $1.00 in 3 years. With the left over 11 cents, you could purchase LEAPs (Long-term Equity AnticiPation Securities). A LEAP is basically a long term option – they can last for 3 years before expiring.

The 89 cent strip bond that matures in 3 years is basically giving you a 4% return on your money. Since it matures at $1.00 this is in effect your principal guarantee. Even if the LEAP expires worthless, you will have your original $1 back from the strip bond. But, let’s say you bought WIU on the Montreal Stock Exchange – this is a LEAP on the S&P/TSX 60 Index. If this LEAP is in the money after three years (above the strike price) then you will have your $1 from the strip bond PLUS the value of the LEAP at the end of 3 years. Let’s say the LEAP has tripled in value to 33 cents (not always the case). Now your original $1 has grown to $1.33 in three years (a cumulative return of 33%, and an annualized return of 9.97%) and you had guaranteed your principal the entire time.

If your investment amounts are large, your fees (on a percentage basis) are lower. You also don’t have any clauses that collapse the structure on you – so you can participate in any positive performance of the underlying equity investment for as long as YOU want. If you wanted to collapse the structure, you get the market rates for the strip bond and the LEAP – both of which are liquid. (Many PPN secondary markets are provided by the issuers only.)

I used the example of strip bonds for simplicity’s sake. Note that transaction costs don’t reach economies of scale until you are dealing with larger investments (as usual), so this normally won’t work as well if you are trying to do this with $10,000.

Please consult with your own qualified financial advisor before contemplating or engaging in a strategy like this.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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