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Prudent Investor Update, November 7, 2018

Demystifying PPNs: Are they right for you?

Principal Protected Notes (PPNs) are fairly complex financial instruments. They allow an investor to get some exposure to equity markets, while still guaranteeing the initial investment. For that reason, investment brokers often come knocking at the doors of municipal governments touting PPNs.  After all they seem to offer no downside with potential upside in the form of positive equity market returns.  

Municipal investors have considered or invested in PPNs for good reason. Prior to the new prudent investor rules, municipalities were only authorized to invest in equities either through the ONE Equity Portfolio or via PPNs.  

To know if PPNs make sense for your municipality, it is important to understand how they are structured, notes Dino Bourdos, Head of Investment Solutions for Guardian Capital LP. He explains that at their core, fully guaranteed PPNs are made up of two key components:
  1. The purchase of a zero-coupon bond to guarantee the principal at maturity; and
  2. A call option on the underlying market (or security) you desire exposure to.
A zero-coupon bond is a debt security that does not pay interest.  The investor buys it at a deep discount, a bit like a money market investment, and it returns its full face value at maturity.  The difference between the price the investor pays, and the amount returned at maturity, represents the prevailing interest rates.  If you invest $100 with a PPN manager, she may invest say $85 in a strip bond that will return $100 at maturity, thus providing the security for the guarantee of return of principal. Because the strip bond matures usually in six to ten years, it is important to consider that PPNs are for this fixed term only. If funds are needed before then, penalties and/or market movements will affect what you receive, and the guarantee is voided

Options contracts are purchased with the residual proceeds available after the zero-coupon bond is purchased and after various fees and commission have been deducted.  In our example, this amount would be $15 less fees.  In some cases, there is limited transparency on fees with PPNs, so it is important to ask questions from the broker about this aspect of the investment, as these costs vary from provider to provider. The amount of exposure to the stock market will be limited by the size of these fees, which can vary. Call options do not accrue and pay dividends, therefore PPNs won’t participate in the total return of the market. The issuers of the PPNs may structure this part of the note in many different ways.

The example below illustrates a hypothetical PPN in which the call options are on a Canadian stock market index, the S&P/TSX 60 for five years. (This index is replicated by an exchange-traded fund managed by Blackrock, the XIU ETF.) There are no fees or commissions calculated in this illustration and the actual experience may vary from what is illustrated here.
Image of no fees or commissions calculated in this illustration and the actual experience may vary from what is illustrated here.

The blue line shows the expected outcome of the zero-coupon bond with the principal fully guaranteed. The purple and orange coloured lines indicate the fluctuations in value of XIU ETF call options over two different five-year terms.
  • The purple line shows outcomes over the period from 2000 to 2005, when the XIU ETF had a -2.3% total return for the 5-year period. If the market ends down by the time the note matures, there is no value left in the option and it expires worthless.  The principal is protected.
  • From 2009 to 2014, as the orange line illustrates, the outcome was quite different, with the incremental return on the option of 17%. Notably, the XIU ETF delivered a total return close to 78% for that period. There was a substantial difference in participating in the market through the call option given its up-front cost, lack of dividend income and the limited proceeds available to purchase sufficient call options within the PPN.
It’s important to understand that at the time the PPN matures, the call option also winds up, regardless of whether it is an optimal time in the markets. Therefore, as with all equity investments, the return on the equity portion of the note cannot be predicted.

Over periods of six years or longer since 1956, Canadian stocks have always had a positive return, except for one six-year period with a return of -0.5%.  For these reasons, PPNs make sense for extremely risk averse investors who are prepared to pay and give up dividends for the downside protection.  For those who can tolerate the risk of not taking their money out for that timeframe, a direct investment in the stock market will likely generate higher returns.

By demystifying the components of the PPN, municipal investors will be better equipped to determine if the fees and terms provided by the PPNs are consistent with their investment goals and objectives.

For a more in-depth understanding of PPNs, sign up for ONE’s upcoming webinar on the subject, on December 6, 2018 at 11 a.m. presented by Dino Bourdos of Guardian Capital.