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Hitting a Bum Note - The Pros & Cons of Principle Protected Notes - Featured in Financial Post

Updated: Mar 13, 2022

It’s difficult to believe, but it is now 10 years since the Great Financial Crisis had its apex in early October 2008. At the time, I was also managing $200M in private client assets which consisted of public securities, but more interestingly I was co-managing a $400 million Principal Protected Note (‘PPN’) which was issued by one the Canadian banks that was linked to a mutual fund which the firm that I worked at managed.

PPNs were gaining prominence as an investment vehicle of choice for conservative investors, who were, in reality, savers who were unhappy with GIC rates. PPNs were pushed or ‘recommended’ by bank sales staff and commissioned advisors as a strategy to “obtain growth, income and capital protection”. The claims sounded like an investor’s Nirvana; investors get to eat their cake and have it too!

A Principal Protected Note is a structured finance product created by investment dealers which consists of two parts. The first part consists of a structure of a zero coupon bond which guarantees a rate of return as long as the note is held to maturity. The second part of the PPN is an option with a payoff that is linked to an underlying asset or index. Based upon the performance of the linked asset, the payoff will vary and will have the potential for a return, but the return is not guaranteed.

For example, if the payoff is linked to an equity index, such as the Toronto Stock Exchange (TSX), and the index rises 30%, the investor will receive the full 30% gain. In effect, the principal protected securities promise to return an investor’s principal, at the time of maturity, with the added gain from the index’s performance if that index trades within a certain range.

The risk is that the investment does not have a guaranteed return should the issuer go bankrupt and default on all or most of its payments, including the repayment of investors’ principal investment; the investor would lose his or her principal. In reality, these products are essentially unsecured debt with investors of the note falling below the tier of secured creditors.

Now back to October 2008, Lehman had just been allowed to fail and the first iteration of Troubled Asset Relief Program (‘TARP’) did not pass the House of Representatives due to brilliantly played partisan politics by the Speaker during the introduction of the Bill. Each day during that first week of October we were seeing global stock markets opening limit down each morning. I knew that by 2pm we would receive the order from the bank to liquidate another $150M or more in securities in order to meet the margin call that was occurring in regard to the PPN I was co-managing. 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.

While equity markets did not ultimately bottom until March 2009, they recovered relatively quickly due to the unprecedented monetary stimulus of 0% interest rates combined with quantitative easing, along with trillions of dollars of fiscal stimulus. Was all of this government intervention worth it? It’s difficult to say as these policies have distorted equity, credit and real estate markets globally for the past 10 years, along with creating significant social and structural issues.

What happened to the many investors who bought these PPNs from banks with the expectation of earning a higher return for their savings? They experienced what is referred to as a ‘knock out scenario’ or a ‘protection event’ where the underlying asset which the PPN is linked to declines to such a level that the note becomes ‘monetized’. Depending on the issuer, investors would have received their initial investment back, but their loss of purchasing power after inflation was significant over the period of the lifetime of the note, which typically ranges from 5 to 7 years. By the end of December 2008, 169 PPNs were monetized across 12 financial institutions in Canada.

How did the industry fare? Much better than the investors, as the many banks, investment dealers, and commission driven advisors who created and recommended these products earned their significant management fees, operating fees, structuring fees and commissions.

Northland Wealth utilizes an open-architected approach which has the ability to access ‘best in class’ institutional quality traditional and alternative asset class investments. We leverage the buying power of our family office with external asset managers, which often lead to lower management fees for our clients. This provides the potential for higher returns and greater wealth preservation. Our fiduciary responsibility to the families we serve is paramount and our advice has been designed to be devoid of conflicts such as trailer fees and sales incentives.


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