Principal Protected Notes

Principal-protected Notes (PPNs), or Deposit Notes, Linked Notes, or Return Notes as they are also called, were extremely popular from 2005 through the most part of 2007. Though the name suggests a degree of protection, it is important for the investor to understand that it is the principal that is guaranteed to be returned on maturity. There is no guarantee of growth in most cases. As well, PPNs are a longer-term investment with terms ranging from three to ten years.

A principal-protected note consists of two elements. The largest part is the guaranteed portion, which is invested in cash or bank securities such as a bond. The balance is invested in a fund or other securities, including stocks or commodities.

The fund investment may be a hedge fund, mutual fund, or index fund that itself may be based on commodities, foreign currencies, equities, or fixed-income products.

A note is issued specifying the term and conditions. Over the term of the note, the guaranteed portion will compound until it equals the amount of principal initially invested. The fund-based portion is expected to produce growth and a return on the principal. For instance, a PPN worth $100 might see $80 go into guaranteed securities and $20 into funds. The $80 compounds into $100 over the term-to-maturity, and the $20 is allocated to the growth investment portion.

Issuers of PPNs typically try to discourage withdrawals or redemptions before maturity by charging investors a fee to access their funds. An investor may also lose the principal guarantee on early withdrawal.

Fees associated with PPNs have long been deemed one of the disadvantages of the product. For example, it is possible that an investor could pay one fee to the dealer who sells the PPN, another fee to the issuer of the note, another fee to the original manager of the PPN, and another fee to the manager of the investment fund. Other fees that may be charged include performance fees, structuring fees, trailer fees, and swap arrangement fees.

It was virtually impossible for the individual investor to discern the actual fee structure. The introduction of the Principal-Protected Notes Regulations in 2008 set out the requirement that PPN issuers provide clear, simple information that is not misleading, including a statement of risk. It also mandated  institutions that sell PPNs must provide complete information upon request and provide current values on request so that the PPN can be monitored.

PPNs are often not insured by the Canada Deposit Insurance Corporation or the Regie de l’assurance-dépôts du Québec.

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