Capital Protected Investment: Risks, Fees and Regulations

What is a Guaranteed Note (PPN)?

A Capital Protected Note (PPN) is a fixed-income security that guarantees at least the return of all investment principal. This guarantee of initial investment return is their distinguishing feature.

The name used to describe the PPN or “comment” varies. In the US market, they are called structured securities, structured products, or unconventional investments. In Canada, they are called equity-linked notes and market-linked guaranteed investment certificates. There are also structured investment products and structured notes, which are similar to PPN but without principal guarantee.

Under favorable market conditions, PPN is likely to obtain attractive returns. This article outlines the risks and due diligence requirements associated with purchasing notes. The sample calculation is for a bill with a maturity of 8 years, a sales commission of 4%, an annual inflation rate of 2%, and an annual interest rate of 5%. Compound interest occurs once a year.

Key points

  • A principal-protected note (PPN) is a fixed-income security, and you can at least guarantee the recovery of the original amount of investment.
  • In the United States, PPNs are called structured securities, structured products, or unconventional investments, while in Canada, they are called equity-linked notes or market-linked GICs.
  • Compared with stocks and bonds, bills are complex financial investments; therefore, it is important to understand the risks and costs associated with purchasing them.
  • Costs include insurance premiums, commissions, management fees, performance fees, structure fees, operating fees, towing fees and early redemption fees.
  • Risks include changes in interest rates that affect value, zero return risk, higher fees or volatility risks, and applicability and liquidity risks.

Regulation and disclosure

Compared with stocks and bonds, bills are complex investments that contain embedded options, and their performance depends on related investments. These characteristics can make the performance of the bill difficult to determine and complicate the valuation.

Therefore, regulators expressed concern that retail investors, especially immature investors, might not be aware of the risks associated with the purchase of bills. Regulators such as the National Association of Securities Dealers (NASD) and the Canadian Securities Regulatory Agency have also emphasized the need to conduct due diligence on the sellers and buyers of notes.

Although there are other structured investment products and structured notes besides PPNs, other products do not guarantee the return on initial investment-this is a sign of PPNs.

Numerous expenses

Bills are a management investment product, and like all management products, they need to be charged. The bill-related expenses will be higher than stocks, bonds or mutual funds, which makes sense, because the principal guarantee is actually the purchase of insurance. The insurance premium is actually the interest waived for the purchase of bills rather than interest-bearing securities.

In addition to insurance premiums, there are many other explicit or hidden costs. These include sales commissions, management fees, performance fees, structure fees, operating fees, towing fees and early redemption fees.

There is almost no need to pay attention to each expense, but it is important to understand the total amount spent on the expense because it will erode your potential return. Ironically, it is not always possible to know the total cost. For example, for commodity-linked notes, based on a fixed-proportion investment portfolio insurance (CPPI) strategy, transaction costs depend on the volatility of the commodity. This is one of the added complexity of using notes for investment.

The principal guarantee related to the PPN is basically the purchase of insurance; the cost of the PPN is like an insurance premium, so it is higher than the cost of any securities investment that does not provide a guarantee.

Many risks

All investments are accompanied by risks. The risks associated with bills include interest rate risk, zero return risk, expense risk, applicability risk and liquidity risk.

Interest Rate Risk

Changes in interest rates will significantly affect the net asset value (NAV) of the bill. For notes based on the zero-coupon bond structure, the effective interest rate at the time of issuance determines the cost of insurance; that is, zero-coupon bonds.

For an eight-year note, when the annual interest rate is 5%, the cost of the zero coupon bond is US$67.68 per 100 US dollars in face value, and the remaining US$28.32 after deducting the 4% commission (US$100-US$4-US$67.68)) Purchase options . If the interest rate is 3%, the zero-coupon bond will cost $78.94 per $100 face value, leaving $17.06 ($100-$4-$78.94) to purchase options after deducting the commission. After the zero coupon bond is purchased, changes in interest rates will affect the net asset value of the bill as the value of the zero coupon bond changes.

Based on the CPPI structure, for bills, the impact of interest rate changes is more complicated and does not depend on the actual interest rate at the time of issuance. The cost of insurance depends on when the rate changes, the magnitude of the rate change, and the impact of the rate change on the underlying assets.

For example, if interest rates fall sharply early in the maturity period, the cost of zero coupon bonds will increase, thereby reducing buffers. If the rise in interest rates also leads to a decline in the value of the underlying asset, the buffer will be further reduced.

Zero return risk

The risk of zero return is the loss of purchasing power and actual return. The size of each depends on the difference between the interest rate and the average inflation rate prevailing over the term of the bill. In order to maintain purchasing power at an annual inflation rate of 2%, assuming annual compound interest, an investment of $100 must grow to $117.17 at the end of 8 years. The $100 investment with a 5% interest rate will grow to $147.75 in eight years. In this example, the investor gave up a total return of $47.75, of which $30.58 was the actual return ($147.75-$117.17 = $30.58).

However, if the inflation rate averages 3% over the 8-year period, a return of US$126.68 is required to maintain purchasing power, and the actual return forgone would be US$21.07. Calculations show that higher-than-expected inflation increases the loss of purchasing power while reducing actual returns.

Cost risk

Fee risk is the risk that the fees charged will be higher than expected, thereby reducing the return. This risk is most suitable for dynamically hedging notes; those who use CPPI strategies. Over time, if the volatility of the underlying asset increases, the cumulative transaction costs will increase. At the same time, the performance of the bill is unlikely to closely track the performance of its related assets. This is one of the added complexity of notes.

Suitability and liquidity risk

Suitability risk is the risk that neither the consultant nor the investor fully understands the structured product to determine its suitability for investors. Liquidity risk is the risk of having to liquidate bills before maturity due to a weak or non-existent secondary market, which may be lower than its net asset value. Early liquidation, no principal guarantee.

Other risks

In most cases, bills are not suitable for investment by income-oriented investors because there is only one payment and it occurs at maturity. In addition, there is also the risk of not being able to obtain income, and at the same time it will lead to a decline in purchasing power.

An important risk is the credibility of the PPN issuer. If the business goes bankrupt, you may not receive the principal-this means that if your note issuer goes bankrupt, you may lose all your funds.

Potential investment scenarios

If investors strongly believe that notes-linked assets provide an opportunity to exceed the return on fixed-income investments, they can consider buying notes. If investors are satisfied with the risk of no return, buying notes can provide this opportunity without losing the risk of investing the principal.

Unaccredited investors can buy notes whose income is related to the returns of alternative investments (such as hedge funds) to bypass the regulatory restrictions that restrict accredited investors’ direct investment in alternative investments. This is possible because regulators treat bills as debt investments or deposits.

An experienced investor, rather than directly taking a speculative position, may use notes to gain risk exposure. As a bottom line, the bill provides downside protection, guarantees a minimum return, and protects the investment principal.

Bottom line

Bills are complex investments that need to consider a variety of risks and expenses. Remember, as the cost of insurance decreases—that is, as interest rates increase—the stock market tends to be affected. Conversely, when insurance costs are higher and interest rates are lower, the stock market tends to perform better.

Traditionally, in order to obtain higher returns, the customary practice is to increase the risk exposure of the investment portfolio by increasing the proportion of stocks held in the investment portfolio at the expense of cash or fixed-income assets. The use of notes to seek higher returns is accompanied by additional costs implied in the principal guarantee. Before buying a note, determine whether the potential return is commensurate with the risk and additional costs.

Finally, consider paper investment from a portfolio perspective, which means considering its expected return relative to the risks that it adds to the portfolio. If appropriate, the expected return per unit risk of the note will be higher than the return currently provided by the existing investment portfolio.

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