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Should You Buy Principal Protected Notes?

In a previous post, we looked at market-linked GICs and whether they’re something investors should consider. In this post, we’ll focus on a similar kind of product called principal protected notes (PPNs).

PPNs aren’t nearly as popular as GICs, nor as well-advertised. As such, it’s likely that many investors haven’t even heard of them. Nonetheless, they’re sold by most major banks and their total issuance in Canada is in the tens of billions of dollars.

What are PPNs?

So what are PPNs? Like market-linked GICs, PPNs offer investors what seems to be the best of both worlds. First, as the principal protected part of the name implies, a purchaser is guaranteed by a financial institution to get at least their initial investment returned to them at the end of the term. Terms for PPNs vary but five to seven years is common.

On the other hand, the temptation of a PPN is the possibility of a juicy return. The return on these products is linked to a specified index’s performance. It can be as simple as a well-known stock exchange such as the TSX, it can be a blended return that combines the performance of two stock markets, or it can be something more complicated. With the more exotic PPNs, your return might be linked to the price of a commodity, such as oil.

What are the risks?

The devil is in the detail, as the saying goes. And there are many devils with principal protected notes. For starters, unlike GICs (even market-linked ones), PPNs are not considered deposits and therefore aren’t insured by either the Canada Deposit Insurance Corporation or provincial credit union deposit insurance organizations. What this means is that if the issuing bank happens to go bust, your investment is not government-backed. It’s merely a liability of the financial institution itself, which means you’d be in the same boat as other unsecured creditors and likely to lose part or all of your money.

Second, PPNs and market-linked GICs share a downside that’s often underappreciated. Namely, if the underlying market to which the note is tied goes down during the term, all you’ll receive at the end is your initial investment. And while it may seem like you didn’t lose anything, in truth you will have. Why? Inflation.

Assume you invest $10,000 in a PPN that has a term of six years. Over the course of that six years, inflation (the cost of living) rises by a total of 20%. Just to keep pace with this inflation, you would need to receive back at least $12,000 from your initial investment. So if you only get $10,000, what this means is that you’ve actually lost money in inflation-adjusted terms.

Third, unlike GICs, PPNs can come with fees that really eat into your returns. According to a MoneySense article, these sorts of products can come with sales commissions of 3%, which obviously eats into your returns. Furthermore, there are other potential expenses, such as management fees, performance fees, operating fees, and structuring fees.

But wait, there’s more! Want to redeem a PPN early? There’s a chance that when you do so, you won’t get all of your money back. In effect, you’d be selling into a “secondary market” for the particular PPN so it depends to what extent the bank or another investor is willing to purchase (or buy back) your note.

The bottom line

When we reviewed market-linked GICs, we made it pretty clear that they should be avoided (although there are some instances where they aren’t as bad).

In short, PPNs are even worse. You could easily lose money after taking into account inflation. You might get hit with hefty fees. And to top it all off, your money isn’t insured by the government.

Rather than taking a shot at PPNs, you should probably take a pass.

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