[Mid-January 2007]

Retirees and those close to retiring are seeking security as well as healthy investment income, and structured products such as principal-protected notes are meeting their needs by serving up an increasing array of options and features, including tax-advantaged income.

But PPNs can be complex, and there is a price to be paid for the guarantee of not losing money. It is important, therefore, that advisors understand the cost structures of PPN products and inform clients what the trade-offs are — so they can decide whether the protection is worth the extra expense.

“In today’s low interest environment, structured notes have more attractive yields and better upside potential than traditional income securities,” says Stephen Polonoski, assistant branch manager at the Kitchener, Ont., office of Wellington West Capital Inc. “They offer the best of all worlds — limited risk, regular cash flow and growth potential.”

Essentially, PPNs offer a guarantee on invested capital and link returns to underlying investments such as mutual funds, key interest rates, stock or bond indices, customized stock portfolios or hedge funds. The primary attraction of PPNs is that if the notes are held to maturity — typically, five to 10 years — the original nest egg is protected, even if the underlying assets to which the note’s performance is tied fall in value.

If the underlying assets increase in value, investors participate in the gains, although to a lesser degree than if they had simply held the underlying assets because of extra fees on PPNs associated with the cost of the guarantee. The guarantees are typically provided by a major bank or government agency, which issues the PPN. The reputation of the guarantor is an important component of any PPN.

A growing number of PPNs are designed to offer regular quarterly or monthly income, based on the performance of the portfolio that underlies the note. Sometimes, depending on the terms of the note, this income is paid in the form of return of capital, allowing investors to defer income taxes until the note is ultimately sold or redeemed. Other times, the income is in the form of regular interest and is fully taxable each year.

“There have been a lot of recent innovations, and the beauty of some of these structured products is that the investor can get income along the way and still receive the guarantee,” says Jimmy Chu, analyst at Toronto-based Investor Economics Inc. “There’s been a lot of growth and innovation in the marketplace and more features have come into play on these products, offering downside risk protection combined with upside return potential.”

The most recent numbers from Investor Economics indicate the size of the Canadian PPN market was $13.8 billion as of June 30, 2006, about double the $6.9 billion in notes as of Dec. 31, 2004. As of Aug. 31, 2006, there were 657 notes outstanding, beating the 461 notes outstanding at the 2005 yearend and the 291 notes in 2004. And the pace of new issues is ramping up rapidly. For the eight months ended Aug. 31, there were 210 new issues, with the pace continuing in the latter part of the year, Chu says. In all of 2005, there were 182 new issues; in 2002, there were 41.

According to Raj Lala, managing director of Toronto-based Jovian Capital Corp. and president of subsidiary Gibraltar Consulting Group, the advantage of the notes that pay out distributions prior to maturity is that they provide investors with “locked-in” gains. At the end of the day, investors in these notes would be further ahead if there was a market disaster near the end of the note’s term, causing the note to drop below par in value and triggering the guarantee, he says, as the investors would typically get their guaranteed principal in addition to the distributions they had already received.

However, it’s important to read the fine print in the offering documents, as some notes may deduct any income paid annually in the form of return of capital from the principal guarantee at the end.

“The chance to take a gain while you can has broad appeal to an audience looking to create or subsidize an income,” says Lala, whose firm was involved in the creation of some $400 million these notes this past year. “There is immediate gratification instead of having to wait eight years or so until the note matures. However, the yield offered by notes is typically based on how the invested part of the portfolio performs. There is no guarantee on distributions or returns, making this product higher-risk than a bond or GIC, although the potential upside is greater.”

@page_break@Some notes are redeemable at the issuer’s option prior to maturity, which could bring an early end to any distributions anticipated by the investor. And some notes, such as the Royal Bank of Canada’s Issuer Extendible Step Up Note, start off with an initial maturity date of one year but allow the issuer to extend the term for one year every year for the next five years. Royal Bank’s product promises a coupon of 4.7% in the first year, rising gradually each year to 5.5% after five years — providing the bank decides to extend the maturity date every year. In return for giving the issuer the right to call the note, the investor receives a rate higher than a term deposit.

Dan Hallett, president of Win-d–sor, Ont.-based fund analyst Dan Hallett & Associates Inc. , questions the need for the note structure and its additional fees because of the low odds of losing money — without guarantees — in stock or bond markets over the long periods covered by notes.

As well, he points out, some notes are tied to the performance of conservatively managed, stable funds. Examples include Saxon Funds Management Ltd. ’s BMO Saxon Balanced Protected Deposit Notes, which are linked to the performance of Saxon Balanced Fund, and Franklin Templeton Investment Corp. ’s Bissett Bond R.O.C. Class, linked to Bissett Bond Fund. Royal Bank recently issued the Principal-Protected Global Innovators Yield Deposit Note, which offers a guaranteed coupon of 6% in the first year, and a variable coupon in Years 2 to 6 that will be linked to the performance of a global basket of 20 common shares in companies considered to be innovators in their fields. The product imposes a 10% ceiling on the annual coupon.

“The investor makes a trade-off for the benefit of the guarantee,” Hallett says. “Typically, buyers pay a higher fee or give up a percentage of the upside on the underlying asset. There is definitely appeal for investors who are willing to give up some return for the certainty of not losing money. But it’s important that advisors inform their clients what the trade-offs are.”

Here’s how the fees work in one case. Mackenzie Financial Corp. , in partnership with the Bank of Montreal, has just issued Series 4 of its MSP ArMADA protected deposit note, with one version paying a monthly distribution characterized as return of capital, and the other reinvesting any gains along the way and paying them out at maturity. The monthly distribution for the return-of-capital product is based on two-thirds of the average return provided by two Mackenzie global equity funds — Mackenzie Cundill Value and Ivy Foreign Equity, with the remaining third to be paid out at maturity in eight years. The management expense ratio on the mutual fund portion of the PPN portfolio is 2.95% annually, about 49 basis points higher than average MER of the regular versions of the two underlying mutual funds. In addition, a non-negotiable up-front sales commission of 5% is also deducted.

Lala compares PPNs’ extra costs to paying for fire insurance on a house. Although the chances of your house burning down are slim, the insurance that protects you from the financial damage caused by a fire is worth the extra cost.

“A lot of people close to retirement want to keep their nest egg intact, and knowing they will get their money back is appealing,” Lala says.

Return of capital is a tax-effective way to receive monthly distributions relative to regular PPN distributions, which are characterized as regular interest. Regular interest paid by PPNs is fully taxable, in the same way as interest paid by bonds or GICs. This form of income is suitable for investors holding their PPNs inside a registered plan such as an RRSP or RRIF. Return of capital is not taxed. Instead, the adjusted cost base of the PPN is reduced each year by the amount of the return on capital, thereby increasing the capital gain when the security is ultimately sold or redeemed. A note such as Bissett Bond R.O.C. Class not only offers the guarantee that would not be available to investors in the ordinary version of the underlying fund but characterizes the income that would normally be treated as interest income from bonds into more tax-efficient return on capital.

A PPN that reinvests gains yearly instead of distributing them does not trigger any taxes for the investor until it is sold or reaches maturity. If it is held outside a registered plan and is sold prior to maturity, any increase in value is treated as a capital gain. But if the PPN is held to maturity, the compounded increase in value is treated as income, and taxable as such, so investors outside a registered plan would be better off selling before maturity.

Most PPNs use a process of dynamic asset allocation, whereby assets are moved between the underlying growth-oriented funds and a bond portfolio to ensure that the guarantee can be met, and the proportion allocated to bonds changes with the fund’s performance. If performance goes through a negative spell, the allocation to bonds is increased to reduce exposure to volatility. A severe or prolonged downturn could mean that investors have a large exposure to bonds and reduced exposure to growth-oriented assets such as mutual funds, which could ultimately mean a significantly weaker performance for the notes than for the underlying funds. Some PPNs may apply leverage to increase exposure to the growth part of the portfolio. But this strategy can amplify losses as well as gains.

Although investors must hold their PPNs to maturity to receive the guarantee, they can sell earlier at market value if there is a secondary market or if the issuer provides an annual redemption opportunity.

Again, it’s important to read the fine print, as there is often a deferred sales charge applied to redemptions in the first few years, or there may be other costs applied to early redemption. And although guarantors will often redeem securities from investors wishing to cash in early, they typically reserve the right not to do so. IE



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