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Regulators issue warning on principal protected notes

by Wayne Cheveldayoff, 2006-08-03

Canadian securities regulators recently took the unusual step of issuing an “Investor Watch” on principal protected notes (PPNs).

The main message that the Canadian Securities Administrators (CSA), representing provincial securities regulators, put forward is that there are some drawbacks with these notes and if you are thinking of investing in a PPN, be sure to do your research to know exactly what risks you are taking on.

Taking it a step further, although the CSA didn’t say it this way, just because the solid, reliable Canadian banks are involved in issuing or providing principal guarantees for PPNs, doesn’t mean they are a good investment (or at least a good investment for everyone).

The CSA notes that a PPN as an investment product consists of two parts. One part is an investment that promises to return to you the original amount you invest, usually after a six-to-10-year period. A third party, such as a Canadian or foreign bank, guarantees the amount you will receive.

The second part of the PPN is a market-based investment, usually linked to a market index, a fund, or another investment product that offers the potential – but not a guarantee – of a profit on your investment.

“Sellers of PPNs attract investors by promising that they can have the principal amount of their investment guaranteed and still have the prospect of earning a rate of return above what might be provided by a GIC or other investment providing a fixed return,” says the CSA.

The CSA points out the following: (1) there is no guarantee that you will get back more money than you invested; (2) your money is locked up for several years and, if you take your money out early, you can lose the guarantee on your principal and be charged a fee; (3) you might receive little or no profit on your investment, which would leave you worse off than if you had bought a GIC or other investment with a fixed rate of return; and (4) the various fees associated with the PPN can make it harder for you to earn a profit on your investment, even if the underlying market investment performs well.

The CSA provides an example for a $100 investment in a PPN. The majority of your money, say $70, is used by the PPN manager to buy an investment that is guaranteed to be repaid, with interest, after a period of time (such as 10 years).

A bank or insurance company will often provide the guarantee on the investment, since by the end of the guarantee period, the $70 will have grown with interest to $100.

If you take your money out before the 10-year guarantee period expires, you can lose the guarantee and be charged fees for withdrawing.

Also, the guarantee is only as good as the guarantor providing it. Whereas PPNs are often referred to as deposit notes, they are not insured by the Canada Deposit Insurance Corporation (which insures most other bank deposits to a maximum of $100,000 per customer).

The CSA doesn’t provide specifics on the amount of fees charged. But in addition to the early redemption fee, it lists the others that could apply, including selling commissions, management fees, performance fees, structuring fees, operating fees, trailer fees, and swap arrangement fees.

These fees can eat into potential returns. With $70 of the $100 tied up in purchasing the guarantee, the manager has only $30 to work with to pay fees and generate a reasonable return on the full $100. (There is really only $25 to work with since PPNs normally pay a 5 per cent commission to the selling broker or investment advisor on the $100 invested.)

According to the CSA, with this diminished amount of money, some PPN managers take high risks to try to obtain the desired returns. But with risk comes the potential for loss.

“This may mean that, in the worst case scenario, you will still get back your $100. However, you should consider the fact that you will have to wait 10 years to get your principal back with the possibility of no profit having been earned on your investment at all. This can have a negative impact on the growth of your retirement fund.”

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2006 Wayne Cheveldayoff