About principal-protected notes
What is a principal-protected note?
A principal-protected note is an investment vehicle providing exposure to underlying securities (i.e. a basket of equities, commodities, preferred shares or income trusts) while protecting 100 per cent of the investor's capital, as long as the Notes are held until maturity.
What's the role of principal-protected notes in a portfolio?
Principal-protected notes are a hybrid asset class, combining the potential capital appreciation of growth-oriented investments with the security of fixed-income investments. That means they can reside in the equity or fixed-income portion of a portfolio.
They can play a number of roles, depending on the investor's individual situation:
• Replace cash or GIC holdings to boost potential returns
• Add diversification to a portfolio overly reliant on fixed-income investments
• Provide enhanced returns to a portfolio that's underweight in growth-oriented investments due to the investor's aversion to risk
• Preserve the capital of a portion of the investor's holdings to reduce overall portfolio risk
Who can benefit from principal-protected notes?
• Investors who need higher returns to reach their financial goals, but are concerned about market volatility
• Cautious investors waiting for a time when they feel safe investing in growth-oriented vehicles again
• Individuals with fixed-rate GICs or other low-interest investments looking for enhanced returns
• Segregated fund investors who want 100 per cent protection and a shorter maturity period
• Individuals approaching retirement or already retired who are especially concerned about protecting their savings
What are the advantages of principal-protected notes?
• Higher return potential than fixed-income investments: Principal-protected notes invest in equities, high-yielding income securities and/or commodities that can provide enhanced returns.
• No risk to capital: 100 per cent of the original investment is protected if held to maturity.
• Liquidity at net asset value (typically subject to an early trading charge)
What are the risks of investing in principal-protected notes?
• Principal-protected notes are not guaranteed by the Canadian Deposit Insurance Corporation (CDIC).
• While investors are entitled to receive their principal upon maturity, there is no assurance that the notes will show any return. The value of the notes upon maturity is based on the market price of the notes' underlying securities.
• Principal-protected notes are not exchange-listed but trade in a secondary market. It is not possible to predict how the notes will trade in the secondary market or whether such market will be liquid or illiquid.
Speak to your financial advisor for more detail on risks associated with investing in principal-protected notes.
How does a principal-protected note work?
There are two ways to structure a principal-protected note:
1) Zero-coupon bond structure
In this structure, a portion of the investment capital (usually about 75 per cent) is used to purchase a zero-coupon bond with a face value equal to the initial amount of capital. The bond matures at the same time as the note, paying back the initial capital. That provides the guarantee. The remainder of the capital (about 25 per cent) is invested in derivatives that replicate the performance of the underlying securities.
2) Dynamic allocation or Constant Proportion Portfolio Insurance (CPPI)
In this model, the issuer does not purchase the bond that provides the guarantee of capital, as in the zero-coupon bond structure. However, a sophisticated formula ensures that there is always sufficient money to purchase the guarantee later if necessary.
As long as performance is positive, the model allows up to 100 per cent of the assets to be invested in the desired underlying securities. However, in a down market, the model has trigger points where it automatically begins to move money away from active investments and into a protection component, usually money-market instruments. As assets increase, money-market allocations are moved back into the active investments. If assets decline far enough, the formula-based model orders all the assets to be sold, and the zero-coupon bond is purchased to guarantee the investors' capital at maturity.
When are principal-protected notes available for purchase?
Notes are made available through an initial offering, which has a limited selling period of about six to eight weeks. Once the selling period is over, some notes may be available through the issuing bank at NAV, or they may be available at a later date through the launch of another series of notes.
Click here for information on Sentry Select's principal-protected notes.