Holders of principal-protected notes have discovered the pros and cons of holding these securities after the equities markets went into a collective tailspin.

PPNs — which come in maturities of three to 10 years — guarantee the amount invested while linking returns to an underlying investment. What’s good about PPNs is that no matter what happens to the underlying investment, noteholders will not lose their principal if they hold the notes to maturity.

But what is not so good about PPNs is the limited opportunity for returns, particularly now that equities’ values have plummeted. The losses have been so great that some PPN managers have triggered “protection events” or “knockout events,” causing them to convert their PPN portfolios to bonds — in other words, “monetizing” the PPNs — so the principal guarantee can be met at maturity.

Monetized notes, however, no longer have exposure to the underlying asset — mutual funds, hedge funds or baskets of funds or stocks — on which the return was originally based. These notes, then, can no longer participate in the returns of the underlying asset and have stopped paying income distributions. This means noteholders are unable to participate in any market recovery that may occur during the lifetime of their notes. The best a client can expect if his or her PPN has been monetized is to redeem the note at par when it matures.

“There are risks and costs to principal protection,” says Andrew Guy, portfolio manager with Sentry Select Capital Corp. in Toronto. “Investors in PPNs receive a guarantee on their principal, and that’s what we’re seeing happen.”

The problem with a protection event, he says, is that, in effect, clients are holding notes that have sold their market-based holdings at the worst possible time and so those clients will forfeit any upside potential. “The current structure of most notes,” Guy says, “means PPN holders are doing the opposite of buying low and selling high.”

The question facing many clients, then, is what to do if their PPN has been monetized. Does it make sense to hang in for the years remaining until maturity for the sake of the guarantee? Or would clients be better off redeeming their notes at current asset values — assuming the issuer provides a market — taking their proceeds and investing in something else?

Some PPN issuers do provide a secondary market for the redemption of the notes, particularly if the notes were issued by a Canadian bank. But redemption privileges are not guaranteed in all cases. Redeeming at current market value will typically involve realizing a loss on the note, and could also trigger early redemption fees.

On the upside, in many cases, PPNs have suffered smaller drops in value than those experienced by the underlying assets to which the notes are linked. Many PPN managers reduced their exposure to the underlying assets and increased their exposure to bonds on a gradual basis, as the value of the underlying assets fell. As a result, their exposure was reduced as market losses worsened.

“We’re examining what we need to make up the loss,” says Bryan Snelson, a financial advi-sor with Raymond James Ltd. in Mississauga, Ont., “and whether we can do better on something else than by holding the note to maturity. Every client knows the worst-case scenario is that he or she will get the principal back when the note matures; the question is whether it makes sense for the client to stay with what he or she has or get into something else.”

Most of his clients are deciding to get out of their PPNs and into a security with yield as well as some upside, such as conservative, dividend-paying blue-chip stocks. Even with no appreciation, Snelson says, the compounded yield on some of these securities will put clients in a better position than continuing to hold their PPNs to maturity.

And if there is a market recovery, those clients are positioned to participate. If the market falls over the next few years, however, the clients have forgone the principal protection by dumping their notes prior to maturity.

“Yields on blue-chip stocks have been boosted dramatically by falling stock prices,” Snelson says. “We want to give clients a fighting chance to maximize investment returns without exposing them to undue risk.”

@page_break@Although stock markets have historically shown an average annual compound return of 9% over the long term, says Luke Seabrook, executive managing director and head of financial products with BMO Capital Markets Inc. in Toronto, the risk is whether or not we will be in a normal environment in coming years.

“If the client stays in the PPN, he or she is guaranteed to get his or her money back,” Seabrook says. “If the client cashes out, he or she is depending on market-based returns, which are unpredictable. Right now, we’re in a very different market than people have seen for decades. We don’t know how long it will take markets to recover. PPNs have done exactly what they were supposed to do, which is protect principal for risk-averse investors.”

Raj Lala, presi-dent of InCapital Man-agement Inc., a Toronto-based manufacturer of structured products, says the decision to sell a PPN now will be influenced by the magnitude of the drop in asset value, the number of years left to maturity and the cost of any redemption fees. Being locked in for a year or two now and getting money back is an easier decision than staying put for more than five years, by which time it is more likely the noteholder will have missed out on the upside of the recovery. Redemption fees vary but generally start at 7% for the first three years, then drop gradually to nothing.

“If you’re three years away from maturity and your note is trading at 80¢ on the dollar, you would have to be confident that you could do better in something else to justify moving out,” Lala says. “Although many people who bought the notes are disappointed from an income perspective, they would have been worse off if they had owned the underlying asset directly.”

In hindsight, income-seeking investors may have been better off if they had bought guaranteed investment certificates, which guarantee both income and principal. However, PPN buyers were looking for upside potential, which GICs do not offer but the equities investments underlying PPNs do. And PPN buyers were reassured by the notes’ guarantee of principal at maturity.

Although PPN offering documents presented protection events as a worse-case scenario in the event of severe depreciation in market value prior to maturity, few issuers and buyers expected the market downturn to be so sudden and severe that such an event would be triggered.

“Most of my clients who held PPNs were happy that their losses are limited relative to the market,” says Steve Polonoski, assistant branch manager at Wellington West Capital Inc. in Kitchener, Ont. “The problem is that they are now out of the market and there’s no potential upside. In most cases, we have made the decision to sell the notes, go to cash and look for opportunities to buy defensive equity securities such as high-yield blue-chips and some preferred shares.”

In a November report, James Gauthier, an analyst with Dundee Securities Corp. in Toronto, listed the number of notes from major Canadian issuers that had been monetized: Bank of Nova Scotia had 15 such notes, CIBC had 31, National Bank of Canada had 16, TD Bank Financial Group had one and Royal Bank of Canada had 57. Bank of Montreal had none, as it recently changed the structure of its PPNs to enable a minimum level of participation in the underlying asset at all times, no matter how much values fluctuate. That means there is some potential for a positive return before maturity.

If clients do hang on until maturity, it’s advisable to take a second look at the PPN’s guarantor and make sure it’s a solid institution that can meet the guarantee. Most PPNs sold in Canada are backed by major Canadian or international banks. To date, there have been no problems with defaults. However, the guarantee is only as strong as the company offering it.

IE