Index-Linked Structured Products/Principal Protected Notes

[brucecohen]

From Benefits and Pension Monitor e-mail news:

Desjardins Group is winding down its hedge fund-linked products in an effort to deal with problems in guaranteed investments caused by the economic downturn. It is shutting down ‘principal-protected notes’ (PPNs). The products bought hedge funds to offer its customers the upside of markets, along with a guarantee they would get back 100 cents on the dollar.

[like_to_retire]

- $700 in a bond that will be worth $1,000 at maturity
- $200 in derivatives that would have given your friend upside (it won't now)
- $100 in fees

I've never looked at PPN's, since I always assume this type of product is designed to make the seller some money.

From the above details, it certainly seems to be so.

Why would anyone invest in this product when they could simply buy the $700 strip themselves and invest $300 in the market. This would insure they had their principle returned after the strip matured, and a chance at some market return?

ltr

[queerasmoi]

Why would anyone invest in this product when they could simply buy the $700 strip themselves and invest $300 in the market. This would insure they had their principle returned after the strip matured, and a chance at some market return?

ltr

Because these notes are marketed to people who aren't investing enough money to do that? Or who don't know how to play with options? Buying bonds directly is not a reasonable option in terms of the spread imposed by brokerages, until you have a certain amount of cash to play with.

In general though, I think people shouldn't invest in products whose inner workings are beyond their understanding. And these products are targeted to exactly those people.

[SoninlawofGus]

In general though, I think people shouldn't invest in products whose inner workings are beyond their understanding. And these products are targeted to exactly those people.

Although I mostly agree with your point, it's worth noting that the same could be said many financial products these days. How many of us really understand the hidden risks of the stocks in our portfolios? Part of this game is trusting what we hear and read, and the proclamations of our institutions and government. In an increasingly complex world (financially and otherwise), it's often hard to know what or who to believe.

Granted, PPNs are confusing instruments and have been less regulated than they should be -- but can the same not be said of AIG, Lehman, and the rest?

[queerasmoi]

True - but still, there's a big difference in complexity between:

"We invest your money into X number of companies on the stock exchange."

"We invest a portion of your money into call options on an index that tracks X number of companies on the stock exchange, invest a portion of it in fixed-income, and you get at least your principal back."

"We leverage a portion of your money into hedge funds that earn money by arbitrage, short-selling, leverage of their own, derivatives, dark pools of liquidity; and we also invest a portion of it in fixed-income and you get at least your principal back."

Or one product my parents bought into on their advisor's recommendation:
"We invest your money in a basket of companies on the stock exchange, and then at our own discretion we write covered call options, and cash-covered put options. And then we spew out a quarterly return of capital distribution whether or not the fund is making money."

[like_to_retire]

And then we spew out a quarterly return of capital distribution whether or not the fund is making money

Isn't that what income trusts are all about?............

ltr

[SoninlawofGus]

queerasmoi, no argument with your points. Oddly, it could be argued that some PPN offer quite a bit more disclosure than some equities. If you read the fine print of PPNs, many of these are clearly a bad deal even from what is disclosed. But an investor in AIG in say April probably didn't get that same level of disclosure.

[Bylo Selhi]

'Tax event' may be next for bruised PPNs

For a supposedly safe investment, there sure are a lot of risks associated with principal-protected notes.

Tax changes being considered by the Canada Revenue Agency could, in the words of one issuer of principal-protected notes (PPNs), “have a material adverse effect” on these investments...

Currently, PPN holders pay taxes on any gain they realize when their notes mature, usually after three to 10 years. The change under consideration could require investors to pay taxes on any gains on an annual basis.

The CRA wouldn't comment on the review. But tax expert Paul Hickey of the accounting firm KPMG said the key issue for agency is that it's possible to buy and sell PPNs before they mature on what's called a secondary market. If a value can be put on a PPN for the purpose of selling it before maturity, the same value can be used to determine whether a theoretical taxable gain applies.

“As the CRA has become aware that there is a secondary market on which investors may sell these notes, it is now proposing that the pricing on the secondary market be used to determine an annual interest accrual amount to an investor for tax purposes,” Mr. Hickey wrote in an e-mail. In other words, investors may have to report gains on their PPNs on an annual basis and pay taxes where applicable.

If the CRA goes ahead with this change, and there's no certainty it will, then PPNs would be lumped in with strip bonds on the list of investments that are best held in registered accounts...

[SoninlawofGus]

In practice, how could they do this? Assume the market goes up 100%. The PPN holder pays 100% interest , just like a strip bond. That's all well and good for a strip bond holder, who will eventually get their interest at maturity. But a PPN holder may then lose all of that at maturity; there is no guaranteed gain. With no ability to get the money back, the holder will have paid tax on nothing.

[Bylo Selhi]

In practice, how could they do this?... But a PPN holder may then lose all of that at maturity... the holder will have paid tax on nothing.

IANATL but I imagine in that case they could claim the tax back -- the year following maturity. Yet another reason to avoid these suckers at, um, all costs.

[SoninlawofGus]

In that case, if hyperdeflation takes hold, it's all for the best.

[Bylo Selhi]

The Street should do the right thing. Dig a grave for those wretched PPNs

If we've learned anything in the past year, it's that we don't want to buy something we don't understand and/or is a layer or three removed from the underlying asset, whether it be stocks, commodities or home loans. Because of their complexity and poor disclosure, PPNs are incomprehensible to all but the most sophisticated investor and adviser. Most people can't possibly know what tradeoffs they are making when they buy a note.

[jackbauer]

With most PPN's down significantly, some have very attractive yields to maturity. Most (well ok, some) are backed by the banks, and they all have a bond component that will mature at 100.

I'm just wondering what your thoughts are.....should investors be looking at some of these now as fixed income alternative? I am talking about existing ones, not new ones.

I'm not posting this to get into a discussion of the merits of PPN's. I'm pretty sure all here would be of the same opinion.

[DanH]

I doubt it would be worthwhile Jack. When a PPN 'monetizes' it basically reverts to being fully invested in a bond to ensure that the market value of the net assets today will be enough to repay the original investment at maturity.

In other words, even though they're down now, the yield to maturity should approximate the yield to maturity that is available in the gov't or investment grade bond market. I haven't looked but most of these things have a quoted NAV so the calculation can be done. I haven't looked at this but I can't imagine they'd offer anything great today that I can't find in a bond.

Where the deals may be is in seg funds. And the deal is only for people who are already in them. But if you're part way through your ten year maturity and your fund offers 100% of capital at the end of a decade; you could be sitting on an attractive guaranteed return. Again, I haven't looked at specific examples recently but the tech bust held a few such gems.

[randomwalker]

I was looking here at so-called "Life Cycle" funds and in particular IA Clarington Target Click Funds to see if there was anything of interest.

"IA Clarington Target Click Funds are Canada's First Guaranteed Mutual Funds and are now priced at a discount to their guaranteed price at maturity. These mutual funds are designed to provide the returns of a balanced portfolio over the long term while guaranteeing at the scheduled maturity date the highest month-end price ever achieved over the life of the fund."

http://www.iaclarington.com/default.aspx?id=120

also this,

"The guarantee is an unsecured obligation of Fortis Bank S.A. / N.V. and any payment under the guarantee is subject to the risk that the bank will have insufficient assets to make the payment."

http://www.iaclarington.com/Default.aspx?id=339

[Shakespeare]

"The guarantee is an unsecured obligation of Fortis Bank S.A. / N.V

Which may or may not be worth anything now.

[DanH]

"The guarantee is an unsecured obligation of Fortis Bank S.A. / N.V

Which may or may not be worth anything now.

ABN AMRO was the original guarantor on the Target Click products. When Fortis took over ABN, Fortis became the new guarantor. I forget who is taking over Fortis but I assume that the acquirer will become the new guarantor - though I haven't seen any confirmation.

[Shakespeare]

I forget who is taking over Fortis

The guv'mint. Which one depends on which part. This part may be the Dutch.

[queerasmoi]

http://www.thestar.com/business/article/594748

Christine is 57 years old and hopes to retire in a few years.

Last July, at her independent adviser's recommendation, she bought what she thought was a bond with a three-year term and a yield of 6.6 per cent a year.

Only when she received a letter last Dec. 1 did she realize – with horror – what she had bought.

Instead of a bond, she owned a principal protected note, or PPN. She would get back the amount invested only in July 2023.

[randomwalker]

http://www.thestar.com/business/article/594748

Christine is 57 years old and hopes to retire in a few years.

Last July, at her independent adviser's recommendation, she bought what she thought was a bond with a three-year term and a yield of 6.6 per cent a year.

Only when she received a letter last Dec. 1 did she realize – with horror – what she had bought.

Instead of a bond, she owned a principal protected note, or PPN. She would get back the amount invested only in July 2023.

Ellen Roseman should be following up on this story as naming and interviewing the advisor in question along with talking to Dynamic funds.

[queerasmoi]

I forgot to quote the important bit about remedies:

She will be meeting tomorrow with her investment dealer, which markets services to university graduates, to discuss compensation.

It's probably a good idea not to name the advisor in a newspaper quite yet - it still gives the dealer time to make things right. And it provides leverage in case the result is not satisfactory.

I say it again and again... complicated financial products just shouldn't be sold without a full briefing on their risks and their content. A line to the tune of "It's like a bond!" should ring warning bells.

[squash500]

I forgot to quote the important bit about remedies:

She will be meeting tomorrow with her investment dealer, which markets services to university graduates, to discuss compensation.

It's probably a good idea not to name the advisor in a newspaper quite yet - it still gives the dealer time to make things right. And it provides leverage in case the result is not satisfactory.

I say it again and again... complicated financial products just shouldn't be sold without a full briefing on their risks and their content. A line to the tune of "It's like a bond!" should ring warning bells.

The problem is that this particular advisor had no motivation or incentive to properly explain PPNS to his client!

The advisor probably made a 5% commission right off the top .

5%of 30000=$1500

[randomwalker]

"...I say it again and again... complicated financial products just shouldn't be sold without a full briefing on their risks and their content. A line to the tune of "It's like a bond!" should ring warning bells.

I'm not sure this is possible as I don't believe all (many?) advisors understand the products that they are selling.

[squash500]

"...I say it again and again... complicated financial products just shouldn't be sold without a full briefing on their risks and their content. A line to the tune of "It's like a bond!" should ring warning bells.

I'm not sure this is possible as I don't believe all (many?) advisors understand the products that they are selling.

What else is new ?

[Bylo Selhi]

"...I say it again and again... complicated financial products just shouldn't be sold without a full briefing on their risks and their content. A line to the tune of "It's like a bond!" should ring warning bells.

I'm not sure this is possible as I don't believe all (many?) advisors understand the products that they are selling.

What makes you think his comment was directed at investors?