Principal Protected Notes "PPNs"

[DavidR]

An educational article from the Globe How to protect yourself from PPNs
The pitfalls of PPNs- the marketers make most of the money.
And how to "roll your own"

Principal-protected notes are a godsend for fee-loving brokers, but these 'dice are loaded' and can erode your wealth through inflation

[queerasmoi]

Interesting, although PPNs in general use options rather than direct market exposure, so that the "leftover" portion of the initial principal is leveraged. Either way, yup, this is how to do it.

Of course: there is still the chance of losing purchasing power to inflation! In theory, one would counteract this by purchasing an RRB strip except for the fact that these are hard to come by and only available to mature in specific years.

[travesty]

Personally, I thought the article was weak and possibly misleading. I agree with the basic sentiment that you should say away from PPNs, because the retail markup is too high and there is an inherent loss of flexibility in having someone build it for you, but stuff like:

With derivatives-based PPNs, figuring out what fees are being charged is especially challenging. That's because the fees are factored into the price of the underlying options, so only a derivatives expert can figure it out, said Peter Loach, an independent analyst.

I'm assuming he's talking about the option premium, or otherwise the market pricing of the option, so characterizing these as "fees" is a bit sneaky - this is the price you pay for the asymmetric payoff offered by the buyer of the option (and the corresponding risk taken by the seller).

Similarly for the comments about the returns not including dividends - this isn't necessarily the bank "stealing" your dividends - but rather than the kinds of derivatives used a priced against market indexes, which do not include dividends. The price factors this in, so you aren't necessarily losing anything.

As QaM points out above, real PPNs are probably created using options - yet every "roll your own" type recipe I've seen uses the recipe shown in the article - investing enough in FI to get your principal back, and the remainder in a plan long market investment. A quick look would show that this doesn't really reproduce the return structure of a PPN well at all. For one, the chance of your market investments going to zero is very small (never happened in history in the US or Canada, or anywhere I've heard of), and even say a 20% drop is fairly rare, so your actual return will likely be far more than your principal (granted, this is good) - while PPNs have a good chance of returning only exactly your principal (I believe if the market is down, you get just your principal).

The flipside is that what you constructed doesn't really work anything like a PPN on the upside. For example, 3-year PPNs are sold with a 60% participation rate - you participate in 60% of the market upside. Let's say you do really well and get 3% p.a. on a 3-year GIC to roll your own PPN. You need to put 91.5 cents of every dollar into the GIC, and have 8.5 left to contribute to the market. If the market goes up 30% total, you'll have 100 + 8.5 * 1.3 = 111.05 cents for every dollar you put in. That's just over an 11% gain. That's a far cry from participating in 60% of the gains! It only gets worse with larger increases (30% is hardly extraordinary - it's about the long term average of the equity markets - granted, including dividends).

[marty123]

The flipside is that what you constructed doesn't really work anything like a PPN on the upside. For example, 3-year PPNs are sold with a 60% participation rate - you participate in 60% of the market upside. Let's say you do really well and get 3% p.a. on a 3-year GIC to roll your own PPN. You need to put 91.5 cents of every dollar into the GIC, and have 8.5 left to contribute to the market. If the market goes up 30% total, you'll have 100 + 8.5 * 1.3 = 111.05 cents for every dollar you put in. That's just over an 11% gain. That's a far cry from participating in 60% of the gains! It only gets worse with larger increases (30% is hardly extraordinary - it's about the long term average of the equity markets - granted, including dividends).

I don't understand your math. You seem to include shares rather than options in your calculations. Options provide leverage. Here's quick numbers I come up with based on your 91.5%/8.5% mix:
- Have $1000 available
- Put 915 in GIC
- Put 85 in XIU Mar 2012 call with $16 strike price (XIU closed at $16.25) with a $2.20 premium

You have the upswing of about 38 XIU stocks, which have a market value of about $627. That's a 62.7% market participation. There's further opportunity to increase that participation, as the call is only 29 months. Remember that both the PPN (read the prospectus) and the home-made version do not include dividends in their definition of "market participation".

I picked the more "intuitive" option (longest maturity, closest strike price). There are certainly more optimal combinations.

[bwalter]

The flipside is that what you constructed doesn't really work anything like a PPN on the upside. For example, 3-year PPNs are sold with a 60% participation rate - you participate in 60% of the market upside. Let's say you do really well and get 3% p.a. on a 3-year GIC to roll your own PPN. You need to put 91.5 cents of every dollar into the GIC, and have 8.5 left to contribute to the market. If the market goes up 30% total, you'll have 100 + 8.5 * 1.3 = 111.05 cents for every dollar you put in. That's just over an 11% gain. That's a far cry from participating in 60% of the gains! It only gets worse with larger increases (30% is hardly extraordinary - it's about the long term average of the equity markets - granted, including dividends).

I don't understand your math, but here's the numbers I come up with based on your 91.5%/8.5% mix:
- Have $1000 available
- Put 915 in GIC
- Put 85 in XIU Mar 2012 call with $16 strike price (XIU closed at $16.25) with a $2.20 premium

You have the upswing of about 38 XIU stocks, which have a market value of about $627. That's a 62.7% market participation. There's further opportunity to increase that participation, as the call is only 29 months. Remember that both the PPN (read the prospectus) and the home-made version do not include dividends in their definition of "market participation".

There are possibly other strike prices that are more optimum for the homemade version (less cash in a $17 strike price? Different maturity and more rolls?).

travesty's math is based on buying XIU, not an option based on XIU, which is what the article suggests.

After reading the article, I'd have to say it's misleading and as travesty commented, most of the "downsides" of PPNs raised by the article are just a fact of how they are constructed using options but at the same time that's really the only way to get a decent participation rate.

I think the real debate should be whether the costs of the PPN protection are worth the benefits and perhaps whether the banks are adding a lot of their own fees as well. In any case the "roll your own" method suggested in the article will not generate PPN like performance. Then again, I suppose the author couldn't suggest using options in the "roll your own" approach, after all:

... options and other derivatives the average retail investor has no hope of understanding.

[marty123]

travesty's math is based on buying XIU, not an option based on XIU, which is what the article suggests.

You mean that I have to read the articles I comment on?

[travesty]

Yeah, sorry for the confusion - marty, you are correct and preaching to the choir. My main point was that this article, like nearly all the other advice I've seen warning others off PPNs offers a DIY PPN based on a risk-free FI investment and a simple long position with the extra money. I was pointing out that such a construction looks very different in payout than a traditional PPN - in particular, it typcially pays out higher in down or slightly up markets (since the index isn't going to zero), but has much a much lower upside.

Your example using options is of course the "correct" way to replicate PPN-like performance (something I had left to the reader ). It just frustrates me when people say "PPNs suck, look you can make your own" - when a simple calculation would show that this instrument doesn't have nearly the upside.

Don't get me wrong - I'm not advocating PPNs. I suspect the take for the bank is significant, but I haven't run the numbers. Marty's example shows that this simple construction already does a bit better - nearly 63% exposure, and the option is already ITM to boot.