In the great annals of rip-offs to come tumbling off the Bay Street assembly line, few if any rank higher than principal protected notes.
They sound great, especially as we crawl out from the teeth of the greatest financial crisis in eons. Imagine not losing anything, your principal guaranteed!
But you do lose. Not principal, but opportunity. You should not buy them.
A principal protected note, simply put, is a hybrid investment that gives you exposure to some kind of investment - and asset class or basket of shares or mutual fund or commodities - while guaranteeing your principal. Here's a random example: the CIBC U.S. Dollar Premium Yield Deposit Notes. Every bank sells them.
These notes were sold in July, 2008 with a four-year term. The return on the notes is based on the return of a basket of 10 New York-listed blue-chip stocks.
As the offering memorandum describes it, investors would get "potential" coupons of 10 per cent a year if the underlying basket of stocks performed well. To wit, if all the stock prices go up investors get 10 per cent, no matter how much or how little the stocks rise. Each stock that goes up, in other words, contributes 1 percentage point to the coupon.
If some stocks go down, their performance is deducted from the coupon. I wish I could tell you how their math works but frankly it makes no sense to me. In any case, it probably sounds good on paper. But it's no great shakes.
Let's look at how investors are doing so far. Some of the stocks have done well, like Apple, others terribly, like Royal Bank of Scotland. The average return on the stocks since inception excluding dividends is -3.4 per cent.
Given the poor performance of stocks, investors have not likely earned a coupon yet. It's not clear if they will this year either. But at least their principal is guaranteed right?
Big deal. The way to measure this investment is to compare it to buying the stocks and holding them. First of all, dividends matter. Including them, the average return is almost flat.
What's more, the notes have more than two years before they mature. If we assume that the underlying shares return 9 per cent a year including reinvested dividends between now and then, which seems reasonable if the economy is on the mend, the average return on the stocks will be about 17 per cent over four years. So, despite having gone through the worst financial debacle ever, investors might well have been better off just buying the stocks in the basket and holding them through thick and thin. Imagine how bad this PPN would look in normal times? Do you really need this insurance?
It's not cheap. Investors get a return calculated in a way that (it appears) a loss on a particular stock can count more than a gain on another, and doesn't include dividends. Why no dividends?
Because banks use derivatives to construct the notes: the potential upside is based on a custom-built option on the underlying basket of stocks. Options pay no dividends.
You might be inclined to argue that the notes will pay out more in coupons than the 17 per cent you earn from holding the stocks. I'm not so sure. A 10-per-cent coupon sounds great but to get that you need all the stocks' prices to go up. I can tell you by looking at the group that they don't correlate closely (meaning they don't behave the same; some will go down when others go up.) In other words, 10 per cent is unlikely, especially since a negative return can count for more.
Why use such an option to underlie the note? Can't say for sure because the disclosure is weak. But if I were selling this note I'd use this setup because I could profit from assembling the option that way. Don't take my word though. Ask the people who sell them.