Hitting a Bum Note - The Pros & Cons of Principal Protected Notes
- May 1, 2019
- 8 min read
Updated: Apr 17
EDITOR'S NOTE
This article was first published in Financial Post Magazine in May 2019, covering the author's direct experience co-managing a $400 million Principal Protected Note during the apex of the 2008 Great Financial Crisis. The 2026 update refreshes the market context, incorporates developments in the Canadian structured note market since 2020, adds a question-and-answer section for reader navigation, and brings formatting into line with current Artisan standards. The original narrative and thesis are preserved.
You may own a structured note marked “principal protected” and not fully understand what you hold. The label suggests safety. The product is something else: unsecured debt of the issuing bank, wrapped around an option on an equity index, sold to conservative investors who wanted more than a GIC would pay. When it works, it feels like a clever hedge. When it fails, it fails in a way the brochure did not advertise.
What is a principal protected note?
A principal protected note (PPN) is a structured finance product created by an investment dealer. It has two parts. The first is a zero-coupon bond, which guarantees the return of the principal if the note is held to maturity. The second is an option with a payoff linked to an underlying asset or index. If the linked asset performs, the investor receives some defined share of that performance at maturity. If it does not, the investor receives only the original principal back, with no interest earned over the life of the note, and with inflation having eroded its purchasing power over five to seven years.
PPNs were pushed through Canadian bank branches and commissioned advisors as a way to obtain growth, income, and capital protection. The pitch sounded like an investor’s Nirvana: you get to eat your cake and have it too. Most of the people buying them were, in reality, savers looking for yield in a low-rate environment. They were not looking for an equity derivative with credit risk.
How does a PPN actually work?
Consider a PPN linked to the Toronto Stock Exchange. If the TSX rises 30% over the life of the note, the investor may receive the full 30% gain, or some capped version of it, depending on the structure. If the TSX falls, the investor receives the original principal back at maturity. In theory, this looks like upside with a floor.
The floor is not as solid as it appears. The return of principal depends on the issuer remaining solvent and honouring its obligations. If the bank defaults, the PPN is what it always was on the balance sheet: unsecured debt. Investors rank below secured creditors. The guarantee is only as strong as the counterparty behind it.
This is the first detail the sales pitch obscures. The second is the option structure. The option overlay is not free. It is funded by discounting the zero-coupon bond, by capping upside participation, or by building in a knock-out or protection event that monetizes the note if the underlying asset falls below a specified level. When the protection event triggers, the option is stripped out, the principal is locked in cash equivalents at low or zero yield, and the investor receives their original dollars back at maturity, five to seven years later, with no participation in any subsequent recovery.
Who bears the risk when a PPN is sold?
The bank writes the product, charges structuring fees, management fees, and operating fees, and collects commissions paid through its distribution network. The advisor collects a sales commission. The investor takes counterparty risk, opportunity cost, and inflation risk, and gives up liquidity for the life of the note. When the product performs, the fees are paid and the investor is satisfied. When the product fails, the fees are still paid and the investor absorbs the loss of purchasing power.
This is not an unusual structure. It is the standard structure of Canadian structured notes. The product is engineered to generate fees through the manufacturing chain. The sales narrative is engineered to generate demand from savers who would never have bought an equity option outright.
Why did PPNs fail investors during the Great Financial Crisis?
It is difficult to believe that more than 17 years have passed since the Great Financial Crisis reached its apex in early October 2008. At the time, I was co-managing a $400 million Principal Protected Note issued by a Canadian bank, linked to a mutual fund my firm managed. Lehman had just been allowed to fail. The first iteration of the Troubled Asset Relief Program had failed to pass the House of Representatives due to brilliantly played partisan politics during the introduction of the Bill. Each morning that first week of October, global equity markets opened limit down. By 2pm I would receive the order from the bank: liquidate another $150 million or more to meet the margin call on the PPN. I knew what was coming each afternoon before the phone rang. The stress of each day was quenched with a couple of martinis in order to fall asleep. Each morning I awoke to do it all over again. For three days this happened. Then, like peace breaking out on a battlefield, the forced selling stopped.
Equity markets did not ultimately bottom until March 2009. They recovered relatively quickly on the back of unprecedented monetary stimulus, including zero-percent interest rates, quantitative easing, and trillions of dollars of fiscal support. Whether the intervention was worth it remains a fair debate. What is not in debate is what happened to the investors who bought PPNs in the years leading up to 2008.
The vast majority of equity-linked PPNs were monetized during the crisis. The underlying indices fell far enough to trigger the protection events written into the structures. Once monetized, the notes were converted to cash equivalents for the remainder of their terms, meaning investors watched the recovery from the sidelines. When the notes matured, investors received their original principal back, minus five to seven years of inflation. The loss of purchasing power was significant and permanent.
The industry fared considerably better. The banks, the investment dealers, and the commissioned advisors who manufactured and distributed these products collected their structuring fees, management fees, operating fees, and commissions through the full life of each note, whether the note paid off or not.
What do structured notes look like in 2026?
Two developments since the 2008 crisis are worth noting. The first is the Credit Suisse Additional Tier 1 capital write-down in March 2023, when approximately US$17 billion of AT1 notes were written to zero during the forced acquisition of Credit Suisse by UBS. AT1 notes are not PPNs, but the event reminded institutional and retail investors that counterparty risk in bank-issued structured products is not theoretical, even for debt issued by a systemically important bank. The second is that the Canadian Securities Administrators have published guidance expressing concern about the suitability of structured notes for retail investors and the adequacy of disclosure in the distribution process.
These are not reasons to avoid every structured note. They are reasons to understand what you own.
When does a structured note make sense for a family office?
A family office evaluating a structured note should start with three questions. What is the counterparty, and how is the family compensated for taking its credit risk? What is the embedded fee, expressed as a reduction in expected return compared to a direct position in the underlying asset? And what liquidity and tax characteristics does the product carry that would not apply to a direct position?
For most UHNW families with access to institutional-quality public and private markets, a structured note is a solution looking for a problem. The equity exposure can be accessed more cheaply through index funds or active managers. The bond exposure can be accessed more cheaply through a diversified fixed income mandate. The principal protection is cosmetic: every family with a properly constructed portfolio already has capital preservation built into the allocation, through asset class diversification rather than through option overlays priced by the issuing bank.
There are narrow circumstances in which a structured note can make sense for a specific objective, such as funding a defined future liability with a known nominal return, or expressing a hedged view on a specific market. Those are the exceptions. For general portfolio construction purposes, structured notes tend to transfer fees from the investor to the issuer in exchange for a payoff profile that is rarely worth what it costs.
At Northland Wealth, we use an open-architecture approach that gives client families access to institutional-quality traditional and alternative managers. The size of the family office allows us to negotiate lower management fees with external managers on behalf of the families we serve. We do not accept trailer fees, sales incentives, or commissions. Our fiduciary responsibility to the families we serve shapes the advice we give, including our general view that structured notes rarely belong in a well-constructed UHNW portfolio.
If you have been offered a principal protected note or a structured product and want a second opinion on how it fits into your family’s portfolio, we are here when you are ready.
Frequently Asked Questions
What is the difference between a principal protected note and a GIC?
A GIC is a deposit product covered, up to applicable limits, by the Canada Deposit Insurance Corporation. A principal protected note is a structured debt obligation of the issuing bank and is not covered by CDIC. If the issuer defaults, a GIC holder is protected by CDIC insurance up to the eligible limit. A PPN holder is an unsecured creditor ranking below secured creditors in a bankruptcy.
Are principal protected notes guaranteed by CDIC?
No. Principal protected notes are not CDIC-insured. The word “guaranteed” in PPN marketing refers to a contractual obligation of the issuer, not a government deposit insurance program.
What is a knock-out or protection event in a PPN?
A knock-out or protection event occurs when the underlying asset linked to the PPN falls below a specified level. When the event triggers, the option component of the note is removed and the remaining value is held in cash equivalents until maturity. The investor receives the original principal back at maturity but no longer participates in any recovery of the underlying asset.
How did structured notes change after the 2008 financial crisis?
Classic PPNs have largely been replaced by auto-callable notes, contingent coupon notes, and barrier-linked notes. These products use different payoff structures but share the same underlying features: an embedded option funded by credit exposure to the issuing bank, distributed through bank channels to investors seeking higher yield than conventional fixed income can provide.
Should a family office own principal protected notes?
For most UHNW families, structured notes do not belong in the core portfolio. The equity and fixed income exposures they offer can be accessed more cheaply and more flexibly through direct investment in the underlying asset classes. Capital preservation is better achieved through diversification across asset classes than through option overlays embedded in bank-issued debt.
About the Author
Arthur Salzer, CFA, CIM, is Chief Executive Officer and Chief Investment Officer of Northland Wealth Management Inc., an independent multi-family office. Arthur wrote the Curve Appeal column in Financial Post Magazine from 2016 to 2022. Before founding Northland in 2011, he spent ten years at TD Bank, including seven and a half years within TD Trust, and nearly eight years at Leon Frazer & Associates. He holds the Chartered Financial Analyst designation and the Chartered Investment Manager designation.
