Principal Protected Notes (PPNs) have significantly grown in popularity over the last five years as issuers provide a partial or full guarantee of the original capital if held to maturity.
There are many different strategies and structures available to retail investors, and the products are heavily marketed and are becoming increasingly complex.
There are mixed opinions in the financial community on whether PPNs make for good investments as not all are the same and should be evaluated on their individual merits.
The potential performance of the underlying investments, time horizon, and liquidity may be significantly different from structure to structure. Your existing investments, investment objectives and risk tolerance are key components to consider prior to determining suitability.
Here’s a general overview of how PPNs work:
They are structured products that generally have a pre-packaged investment strategy, which, at times involve a combination of fixed income and derivatives (options, forward agreements, swaps, etc.) and may use leverage.
For example, Mr. Murray invests $10,000 dollars into a principal protected note (PPN). The issuer of the PPN invests a portion of this money in a risk free bond, which will generate sufficient interest to grow to $10,000 after a period of time, generally 5 or more years. The bond currently costs $8,000 but will grow to $10,000 at maturity. With the remaining $2,000 the issuer of the PPN may purchase other investments and derivatives consistent with the strategy. It is this $2,000 component that provides the investor the ability to obtain a return on their investment. The $8,000 used to purchase the fixed income ensures you receive your initial capital back. Other PPNs may use more complex protection strategies.
Here’s a 10-point checklist to consider:
- Fee Transparency: Many PPNs advertise no management expense ratio (MER), but this can be misleading. There are definitely fees associated with these products and some can be expensive. With many structured products there are selling commissions and fees incurred by the company offering the PPN to set up the structure and the protection strategy. There are also ongoing costs to manage the structure.
- Call Features: Some PPns are “callable,” which is an advantage for the issuing company. If a PPN is doing well, the company may have the right to call the note. Some PPNs are not callable and investors researching PPNs should find the non-callable types more appealing.
- Liquidity: PPNs generally have a one or two year holding period. If an investor sells the investment during the holding period a redemption fee may apply. Prior to purchasing a PPN you should also determine how many years the investment must be held to obtain the principal protection. The time period generally ranges from three to ten years. Interest rates, the cost of protection, and the type of protection are all factors that impact the time period of the structure. Investors should obtain an understanding of both the holding period (to sell without DSC) and the principal protection period. These periods should be consistent with your investment time horizon.
- FundServe: Many PPNs are beginning to trade on FundServe which is the same order entry system used by mutual funds. This provides greater transparency and liquidity.
- Income: Care should be taken to understand the type of income distribution and whether the payments are guaranteed or not. Many of these structures enable the income stream to be treated in a more tax-efficient manner, which is important if the investment is held in a non-registered account. Some PPN structures have a guaranteed distribution while others do not. Many investors may find the guaranteed distribution attractive but there may be disadvantages to such a structure.
- Viability: A key item for individuals considering PPNs is the viability of the firm. Who is guaranteeing the PPN? How much exposure does the company have to this type of structure? Will they be able to follow through with the guarantee if there is a significant market correction?
- Leverage: Investors should ask if the structure they are considering uses leverage. Understanding leverage and its potential use may be required to obtain an understanding of the associated risks and rewards.
- Volatility: The underlying investments and the use of leverage will impact the level of volatility of a PPN structure. Volatility may also be caused by limited liquidity although many issuers are now providing an active secondary market
- Limited Upside: Several PPN structures have limits on the upside potential of the investment. Investors should be aware if the PPN has any capping features. Prior to investing, people should ask what component of any positive performance would they participate in.
- The Structure: A good rule of thumb is to avoid investments that you do not understand and that seem overly complicated. If you do not understand the investment structure prior to purchase then it is unlikely that you will be able to appropriately monitor the position.