Principal-protected notes are raining down upon the market as a multitude of manufacturers compete for the attention of advisors and their clients in the busy RRSP season.

Although there hasn’t been much innovation in mutual funds this year, marketers of PPNs have been busy hanging bells and whistles on their products. The guarantee of the principal amount invested — providing the investor holds to maturity — applies to all PPNs. But this security blanket is being wrapped around a growing assortment of investments, including stock indices, individually chosen baskets of stocks, mutual funds, commodities and managed futures

In some cases, leverage is used. In others, the guarantee is extended beyond the principal to lock in the gains made during the note’s holding period, no matter what happens to the value of the note after the high point was hit.

“The category is exploding in Canada, and it’s becoming a crowded field,” says Dan Richards, president of Toronto-based Strategic Imperatives Ltd. “Investors are suffering a hangover from the tech stock implosion. They want to be sure they won’t lose money, and are willing to trade off some upside for protection on the downside.”

Essentially, PPNs offer a guarantee on the amount invested, while linking returns to an underlying investment. The cost of this guarantee or insurance involves additional fees, which can shave a few percentage points off the returns investors would make by investing normally in the assets represented by the note. If the notes are held to maturity — typically, five to 11 years — the original investment will be returned to the investor intact. If the underlying asset increases in value, investors participate in the upside. Thanks to minimum investment thresholds of $2,000-$5,000, the notes have opened up alternative asset classes, such as hedge funds and managed futures, to retail investors.

The most recent numbers provided by Toronto-based Investor Economics Inc. show 47 issuers, 300 notes and a $5.3-billion market. But these numbers are more than a year old (a new report is imminent). Some observers are guessing the size of the market may have doubled in the past year to $10 billion, and wouldn’t be surprised to see it swell to $100 billion in the next five years. To put that in perspective, the Investment Funds Institute of Canada measures investment fund assets at $570 billion.

“The [PPN] product has become a must-have, and every financial institution out there is getting into the business,” says Earl Bederman, president of Investor Economics. “Due to demographics and the growing number of people entering retirement, more households are moving to the stage at which capital protection is important. At the same time, in a world in which interest rates are low, people who are investing to accumulate retirement funds are looking for some growth potential. We see the linked notes not as a temporary trend but as a permanent fixture of the marketplace.”

The companies involved in PPNs include traditional fund companies as well as hedge fund companies and structured-product specialists. Typically, they partner with a Canadian chartered bank, government agency or major international bank, which backs the note with its guarantee. The strength and creditworthiness of the guarantor is of paramount importance, as the guarantee is the “backbone of the product,” says Robert Bourgeois, managing director of Tricycle Asset Management Corp. , one of the pioneers in the PPN industry.

“Competition is leading to innovation and creativity. But the note product is also becoming increasingly complicated, and there are too many variations for the average advisor to track,” says Dan Hallett, president of Windsor-based Dan Hallett & Associates Inc.

As an example of innovation, ONE Financial Corp. allows investors to switch among its family of 10 notes in a number of investment classes — including gold, energy, dividend income, income trusts, Asian investments and other regional options — and still maintain the original guarantee. These notes are also unusual in that they allow the holders to “lock in” profits on a daily basis, guaranteeing at maturity the highest value achieved at any point during the term. In addition, the notes are structured to provide the potential for enhanced upside returns by applying a leveraging strategy allowing up to 200% exposure to the invested assets.

@page_break@The notes are guaranteed by the Canadian arm of BNP Paribas SA, headquartered in France and the world’s largest bank. The bank will also provide a secondary market in the notes prior to maturity, a feature not offered by all notes.

“People want to participate in certain growth asset categories, but they don’t want to put their life savings at risk,” says Brett Rathbone, senior vice president of marketing at ONE Financial. “Through leverage, the notes can offer enhanced exposure to the underlying assets, with downside protection provided by the guarantee.”

Sentry Select Capital Corp. and Bank of Montreal have teamed up to launch notes tied to the performance of Sentry Select Canadian Income Fund and a notional bond portfolio. The notes will pay a monthly distribution equal to 75% of the income of the portfolio, with 25% of the earnings reinvested. Depending on which note investors choose, the payouts will be considered either return of capital or interest.

“A straight Canadian mutual fund doesn’t have the triple-A guarantor providing a return of principal on maturity,” says Sandy McIntyre, manager of Sentry’s Canadian Income Fund and vice president of Sentry Select. “The note structure is an attractive way to manage risk in a portfolio.”

He estimates the nine-year notes will initially pay a return of about 5.7% monthly, based on the current performance of the underlying income trust fund. But, he emphasizes, the return is not fixed. The notes have a deferred sales charge for the first three years, and BMO offers daily liquidity for investors who wish to sell during that period.

“There is an insatiable appetite for yield on the part of Canadian investors looking for an opportunity to diversify away from bonds, and they want something better than the rates offered by GICs,” says Luke Seabrook, executive managing director of financial products at BMO Nesbitt Burns Inc. “Notes are good for people who don’t want to expose their capital, yet don’t want to sit on the sidelines.”

The scandal created by the collapse of Portus Alternative Asset Management Inc. of Toronto has focused regulators’ attention on ensuring that distributing firms conduct more effective due diligence and carefully examine such features as structure and guarantees on alternative products such as PPNs.

Although the Portus product was portrayed as a guaranteed note, clients’ funds were actually put in a Portus managed account that had other financial obligations, and investors’ assets were not directly guaranteed, says Shaun Devlin, director of enforcement at the Mutual Fund Dealers Association.

The MFDA recently issued a notice outlining its expectations for advisor due diligence on PPNs, saying that while “know your client” is a fundamental part of the advisor’s job, so is knowing your product and taking responsibility for selling it. Devlin says products that are novel or more complex in structure require comprehensive analysis, and advisory firms cannot simply rely on the representations of the issuer. The firms should also identify investors for whom certain products are not suitable, and there should be portfolio concentration limits applied to particular securities or types of products.

“In all cases, the approval process must be independent and objective,” the MFDA notice reads. “Firms must properly follow up on any questions they have raised until they are satisfied they have a complete understanding of the products they propose to sell.”

“Complexity is a factor advisors must consider when determining if a product is suitable for their clients,” Devlin says. IE