Given the widespread fear among investors today, it’s not surprising that financial institutions offer a staggering number of structured products that come with guarantees. Both market-linked GICs and principal-protected notes (PPNs) ensure you will not lose your initial investment, while also offering a chance to profit if the equity markets do well. Investors clearly find this promise appealing—with a lot of nudging from their advisors, no doubt.
Here’s an example. Say you have $50,000, and you’re jittery about the markets and discouraged by the low rates on savings accounts and regular GICs. Your advisor suggests a PPN like this one from Bank of Montreal, which guarantees your investment for six years and adds some possible upside based on the performance of the S&P/TSX 60 Index of large-cap Canadian stocks. No risk of loss and the potential to benefit from a stock market rally: what’s not to love?
A lot, actually. Read the fine print and you’ll learn that the product carries a 3% sales commission, which will cost you $1,500 right off the top, plus a deferred sales charge if you sell it within two years. Like all PPNs, this note also places significant limits on your upside that effectively mean the markets have to shoot the lights out for you to get any meaningful return. (The benchmark used by these notes almost never includes dividends.) I would explain the formula if I understood it, but I don’t. You’re welcome to read the 24-page offering document and figure it out yourself.
A homemade option
A better solution is to forget about this complex and expensive product altogether and build your own for a fraction of the cost, and with a much greater potential for added returns. Here’s how:
1. Start by determining the current yield on six-year strip bonds. A strip bond (also called a zero-coupon bond) doesn’t make interest payments like a traditional bond. Instead, you buy it at a discount and it matures at face value. You can find a long list of them at any discount brokerage. Investment-grade strip bonds maturing in 2018 currently have an effective yield of about 2%.
2. Download this spreadsheet, which I’ve created to do the math for you. Fill in the three highlighted fields: the amount you wish to invest ($50,000), the number of years (6), and the yield on your strip bond (2%). The spreadsheet will give you a present value of $44,399. In other words, this amount compounded at 2% for six years will grow to $50,000.
3. Now it’s time to purchase the investments. Start by buying your strip bond in the amount of $44,399. Then use your remaining $5,601 to purchase an equity ETF such as the Horizons S&P/TSX 60 ETF (HXT), which tracks its index almost perfectly and conveniently reinvests all dividends.
Now, unless your bond defaults, you are guaranteed to have $50,000 in six years, plus some additional return that is tied to the performance of large-cap Canadian stocks. But unlike the structured note, there is no limit on that potential upside: your $5,601 will capture everything the index delivers, minus only the ETF’s minuscule fee.
Plus, you don’t have to rely on a 24-page offering document or Newtonian calculus to get an idea of your potential returns. My spreadsheet calculates these based on several scenarios, using both negative and positive values for the ETF. For example:
Annual ETF return |
Final portfolio value |
Overall annual return | |
-5% | $54,118 | 1.33% | |
-1% | $55,274 | 1.69% | |
0% | $55,601 | 1.79% | |
1% | $55,946 | 1.89% | |
5% | $57,506 | 2.36% | |
10% | $59,923 | 3.06% |
As you can see, if the S&P/TSX 60 delivers a modest 5% annually over the next six years, you would end up with $57,506, which works out to an overall return of 2.36% annually. Hardly awe-inspiring, but significantly better than you would have received from the strip bond alone—and likely more than you would have received from the structured note. Of course, it also came with a guarantee: even if the ETF were to suffer a 5% loss every year, your overall annual return would still be 1.33%, about the same as you would get today from a high-interest savings account.
This strategy is more appealing when interest rates are higher and the horizon is longer. Corporate strip bonds that mature in 10 years, for example, pay about 3.5% today. Using my spreadsheet, you’ll see that you could guarantee your $50,000 over a decade with a bond purchase of $35,446. If equities return 6% over the next 10 years, your overall annual return would be 4.28%. If they deliver 8%, your investment would grow to $81,421, for a 5% annual return. That’s not bad for an uncomplicated investment that comes with almost no chance of loss. Any idea why the banks aren’t recommending it?
Another over-simplified condemnation of principal protected products. Here are a couple things to consider:
1. Principal protected products are offered with or without commissions. To criticize the entire asset class based on the size of a commission is too easy. If the advisor charges a 3% commission in the DIY example then the potential returns will drop.
2. I agree that a 3% commission seems like a lot especially when discount brokerages are charging next to nothing. However, if the product is held to maturity (6 years) then the up front fee equals 0.50% per year. This is much lower than the annual trailer fee charged by mutual funds or fee-based accounts.
3. Principal protected notes are complex but not beyond comprehension. How many people fully understand 2x levered ETFs, Manulife’s wildly popular Income Plus or simply the financial statement of a public company.
3. I challenge anyone to find a principal protected note that will only pay 3.06% per year if the market is up 10% per year over the next 6 years. Most products limit your upside but not usually not by 7% per year. All of the big 6 banks have public websites so it might be worth taking a look.
@Ben: Thanks for your comments.
Not sure I understand what this means: “If the advisor charges a 3% commission in the DIY example then the potential returns will drop.” The DIY example, by definition, assumes no advisor is involved.
You won’t find me defending leveraged ETFs or other products like Income Plus. The fact that there are other equally complicated and expensive products out there is hardly a compelling argument in favour of PPNs.
You’re right that some PPNs may deliver higher returns than what I’ve suggested here. That’s because my example assumes full principal protection even if the equity component suffers a 100% loss, which is virtually impossible. Using the spreadsheet I provide, an investor can make a different decision based on their worst-case scenario.
I always invite readers to do their own research, too, but with PPNs this is mostly futile, because the products are far more complex than the average investor can understand. This is from the offering note of the product I linked to in the post:
So if the markets go up 10% a year, how much do I get?
My guess: the way I read it, if the index goes up 10% per year, you get $151.
However, I must be misunderstanding, because the formula sounds too good to be true. It appears that you get index returns (not compounded) if the index makes less than 8.5% every year (likely) and averages less than 7.11%, BUT you don’t count the negative years. I guess the sales commission and the fact that you don’t get the dividends is the kicker.
I think your homemade version is far too conservative to be directly comparable, since it ekes out a positive return even if the market tanks. Might be closer to spend the investment portion on options (complicated), or dare-I-say, leveraged?.
Good post and thanks for the mention. I’ve often wondered about the psychology of the DIY PPN. Will nervous investors see the strip bond and equity portion as separate investments and fret about the price changes in the equity portion?
More and more I am losing patience with the focus on nominal returns. The guarantee on PPNs make no sense in the world of real returns. I’m think of adopting a new tag line: “Nominal returns are for losers.” (TM) 🙂
@Kiyo: If an astrophysicist like you can’t figure it out, that says something. 🙂
In this PDF, they offer an example of the index going up about 10% annualized over six years, and they say you’d end up with $135.50, which works out to about 5.2%. But their index strips out dividends, so for it to rise 10%, the total return on the stocks would have to be closer to 12.5% annually.
You’re right that my example is very conservative, since it protects your principal even with a complete loss on the equity side. (Not a 0% return, but a –100% return.) But I think PPNs would only appeal to very conservative investors.
There are other ways to do this with options and even leverage, though my suggestion would be to simply lower the amount in the strip bound and raise the amount in the equity ETF according to your comfort level.
@Michael: That’s a good point: at least a PPN has only one moving part to fuss about! And it’s certainly true that a PPN that simply returns your principal (which is a distinct possibility) has not protected your purchasing power. At least a five-year GIC will probably do that (barely).
Thanks for the spreadsheet.
This is a risk management strategy that is particularly useful in part of a registered account at higher interest rates.
One thing to consider is that the higher the rate and the longer the strip the more you will have to invest in the equity ETF.
Also longer dated strips can be very volatile – but you will get your full value held to maturity. There is interest rate risk here which is a function of the length to maturity. Also if there is inflation return of principal may not be enough to compensate.
What I do not like about PPNs is their lack of transparency particularly with respect to fees and as Dan says above with respect to returns. Sure its in the prospectus but its not always easy to comprehend so that comparisons can be made.
Meh, I tried. I can’t resist a brain teaser :).
For those wanting to work from the web, you can also do the present value calculation with a simple WolframAlpha query: http://www.wolframalpha.com/input/?i=fv%3D%2450000%2C+i%3D2%25%2C+n%3D6%2C+annual+interest
My wife has a similar type of investment from National Bank that she purchased in early 2008. The rules are so confusing I have no idea what it will ultimately pay (its for 8 years) and I have not touched it since transferring her portfolio to Investorline.
There was a 40+ page information statement and when I reviewed I really couldn’t make out the calculations. It followed a basket of select global stocks (and not an index), it would reset reset the starting point for measuring performance based on the annual performance and I never really figured it out. The only thing clear is that National Bank can redeem (at its option) these after 4 years (this year) by paying what amounts to 10% interest per year (not going to happen). One interesting thing is that National Bank set up a system for trading these. So, if I want to unload it, I can through Investorline.
@Greg: I guess the one positive thing about your experience is that you’ve held this note during a rough four years, so the stocks in the index may be below their previous value, meaning that you haven’t missed out on any upside.
It’s interesting that there is a secondary market for the note: this isn’t the case with all PPNs. Selling it is certainly an option, but the problem is that it will be almost impossible for you to know its fair value.
@CCP: Each $100 unit purchased in 2008 is now trading at $105 in the market. Here is a description of the product: http://www.fpsgroup.ca/product.aspx?Id=304. I suggest you take a look. It is a really interesting product. While not fully clear, I believe the market crash actually helped a bit because the starting value was tied to the lowest value during the first 13 month period (which was during the crash).
@Greg: Thanks for the link. Since this note is priced daily, you can see exactly what its performance has been like. If you bought it at $100 four years ago and it’s worth $105.51 today, your annual return would be about 1.35%.
Certainly you would have been happy if you bought it right before the 50% market plunge that began in September 2008. But consider this: its price on March 9, 2009 (the market bottom) was $97.25. Today it is $105.51, for a total increase of 8.5%. The global markets are up over 75% during that period.
I have BMO PPN myself. I think all the promises from the document is true. And you don’t need to worry too much about commission because the PPN has return tied to certain benchmark, commission has nothing to do with it’s performance. However I need to point out one thing. PPN is a kind of debt. The money bank borrowed is not really invested into the benchmark, regardless it’s an index, or a group of stocks. The benchmark is only used the calculate the interest of it. It means the PPN has same credit rate as the bank itself. If BMO goes bankrupt, you’ll lost all your money even if the underlying benchmark has a gain. This is quite different comparing to an index ETF. Given the fact that BMO’s chance of bankrupt is very low, I do own some BMO PPN in my portfolio. However I consider put all your money into PPN too risky.
@Michael: It’s true that the PPN is guaranteed by the issuing bank, so there is some amount of default risk, but I think we can all agree that risk is extremely small. It would be virtually the same for a strip bond issued by the same bank.
I should mention that market-linked GICs are different: they are covered by CDIC, so their principal is guaranteed by the federal government.
@CCP: Sure we all feel the risk is virtually zero until Lehman comes into your mind. I personally consider risk of PPN higher than index ETFs.
I just thought of something related required more starting capital;
Buy a CIDC insured GIC.
Calculate the cash flows you will receive from the GIC until it matures.
Invest the equivalent of the cash flows in index ETFs.
A $10,000 5 year GIC might have cash flows right now of $1500 which could be put into the index equity ETF for 5 years.
If market returns zero you still have the 10K.
Like the strip bond strategy the longer the duration and the higher the rates the more equity risk you can take. At average rates you might be able to invest $3500 for 5 years.
I think I would go with Andrew’s strategy. If I am not mistaken you can get higher yields off GIC’s than strips these days.
This is a great article. The detractors will obfuscate the issues through the complexity of the security itself, but ultimately I agree 100% with you: PPNs are basically just zero coupon bonds, some residual derivatives and a whole lot of fees. Just because the instruments can be more complicated than that doesn’t mean their general structure and purpose isn’t glaringly obvious – to rip-off unsophisticated retail investors.
@ Canadian Couch Potato
With regards to your question based on the following product:
At Maturity, a holder will receive the deposit amount of $100 (the “Deposit Amount”) in respect of each of the holder’s Deposit Notes plus a variable return, if any, that will be determined based on the performance of the S&P/TSX 60 Index (the “Index”). The variable return for each Deposit Note at Maturity, if any, will be equal to $100 multiplied by the sum, if positive, of the effective annual index returns on the Index over six successive 12-month valuation periods from the Closing Date to and including the third business day prior to Maturity (the “Final Valuation Day”), with the effective annual index return in each such valuation period being subject to a maximum of 8.5%. Accordingly, the variable return at Maturity cannot exceed $51.00 per Deposit Note (an annual compounded rate of return of 7.11%).
So if the markets go up 10% a year, how much do I get?
To understand this PPN, a simple present value formula will give us the answer as to how much percentage is actually up at maturity.
Present value = Future value / (1 + r)n
Where,
r – Rate of Interest = 7.11%
n – Number of years = 6 years
future value = $151
$151/(1+7.11%)^6
=$100
The present (PV) value formula calculates the exact present required amount from the future cash flow.
If your maturity value is $151 from an initial investment of $100, that means you made a total return on equity of 51%. That is your cap.
In your scenario, the basket of stocks was up 10% annualized, therefore we will use the same present value formula:
Present value = Future value / (1 + r)n
Where,
r – Rate of Interest = 10.00%
n – Number of years = 6 years
present value = $100
$100 = future value/(1+10.00%)^6
future value = $177.16.
Since $177.16 is greater than $151.00, that means you’ve been capped and “sacrificed” $26.16 (=$177.16-$151.00).
Please note that looking at the pdf of the BMO PPN, their rate is capped at 8.5% each year, but if you look at other PPNs from the other 5 Banks, their calculation is beneficial to the investor where there is no cap per year, it’s just an overall cap.