• Principal-Protected Notes (PPNs)
• A principal-protected note is a debt-like instrument with a maturity date, whereby the issuer agrees to repay investors the principal plus interest. The interest rate is tied to performance of underlying asset, such as a portfolio of mutual funds or common stocks, fixed-income investments, a market index, a hedge fund or a portfolio of hedge funds.
• Three main types of PPNs
• Index-linked notes are certificate usually offered in three-year to five-year terms by major banks.
• Mutual fund-linked notes derive their return from an underling mutual fund or set of mutual funds and often have a longer term of maturity.
• Hedge fund-linked notes allow investors to participate in hedge fund returns without the large minimum account size normally required for direct investment and without the downside volatility.
• Although many PPNs are issued by chartered banks, they are not protected by Canadian Deposit Insurance Corporation (CDIC).
• PPNs Guarantors, Manufacturers & Distributors
• The guarantor or issuer of the PPN is the entity that guarantees the principal at maturity.
• The manufacturer helps the issuer design the notes and market them to investors and distributors.
• The investment dealers and mutual fund dealers, which employ advisors to sell PPNs, act as distributors. The distributor receives a commission for each PPN sold.
• The Structure of PPNs
• In the zero-coupon bond plus call option, the PPN issuer invests most of the proceeds in a zero-coupon bond that has the same maturity as the PPN. The zero-coupon bond guarantees the return of principal on maturity. The reminder of the proceeds invested in a call option on the underlying asset.
• In a constant proportion portfolio insurance (CPPI) structure, the portfolio manager shifts the portfolio’s allocation between a riskier asset and a risk-free asset in response to changes in interest rates and the value of the risky asset. As the value of the risky asset increases or interest rates rise, the allocation to the risky asset increases and the allocation to the risk-free asset decreases.
• PPNs are not appropriate for investors who rely on a regular and predictable investment income to fund their lifestyle.
• It is generally accepted that any return from a PPN held to maturity will be taxed as interest income.
• Linked Guaranteed Investment Certificates
• Guaranteed Investment Certificates (GICs) are a type of fixed-income security that offers fixed rates of interest for a specific term.
• Structure of Linked GICs
• Index-, Mutual Funds-, and Hedge Fund-Linked guaranteed investment certificates (GICs) are hybrid investment products that combine the safety of a deposit instrument with some of the growth potential of an equity investment.
• While the principal is guaranteed, the total return on the instrument is not known until maturity, and this may be limited either by a maximum cap on returns or by a participation rate, depending on the issuer.
• A maximum cap on returns means the investment cannot yield more than the maximum return allowed by the issuer.
• A participation rate means the performance of the linked GIC will be equal to a predetermined percentage of the performance of the underlying asset.
• Returns on Linked GICs (main variables used to determine the overall return)
• The initial index level
• The ending index level
• Index growth over the term
• Any maximum cap on returns or a participation rate
• Risks Associated with Linked GICs
• Although the principal is protected, investors must accept the risks associated with an investment that tracks the performance of the stock market, mutual or hedge fund.
• In most cases, investors cannot redeem these linked GICs prior to the maturity date.
• Tax Implication: the return on linked GICs is classified as interest income. If the instrument is purchased outside of a registered retirement savings plan, the gains will be added to income and taxed at the investor’s marginal tax rate.
• Split Shares
• A split share is a security that has been created to divide (or split) the investment attributes of an underlying portfolio of common shares into separate components that satisfy different investment objectives: preferred share and capital share components.
• The preferred shares receive the majority of the dividends from the common shares held by the split share corporation. This structure is of interest to equity investors seeking yield.
• The capital shares receive the majority of any capital gains on the common shares. Capital shares interest equity investors willing to sacrifice dividend income in favour capital gains.
• The preferred share has a priority claim on all available dividends from the underlying portfolio of common shares.
• Tax implications: split shares are issued for a specific term started in the prospectus; at the end of the term the split-share company will redeem the shares.
• Asset-Backed Securities
• Asset securitization is a process that aggregates and transforms financial assets such as mortgage, loans and other receivables into marketable securities.
• Numerous financial institutions use securitization to transfer the credit risk of the assets that originate from their balance sheets to those investors, such as life insurance companies, pension funds and hedge funds.
• The Structure Process
• The originator of the security will group assets together to remove from its balance sheet. The assets are pooled into a reference portfolio and then sold to a separate legal entity called a special purpose vehicle (SPV). Marketable securities are then sold against are the sold against the SPV.
• Most ABS securities now divide the reference portfolio into a number of classes, commonly referred to as tranches, each of which has different levels of risk and reward associated with it. These tranches are sold separately to investors who seek the appropriate risk-return opportunity from the SPV’s assets.
• Asset-Backed Commercial Paper (ABCP) is a particular type of ABS — it has a maturity date of less than one year, typically in the range of 90 to 180 days, with a legal and design structure of an ABS (as discussed above).
• Repayment of a maturing ABCP normally depends on the cash flows emanating front the assets owned by the SPV, as well as the ability of the ABCP issuer to issue a new ABCP (or renew the current one).
• Mortgage-backed securities
• Mortgage-backed securities (MBSs) are bonds that claim ownership to a portion of the cash flows from a group or pool of mortgages. They are also known as mortgage pass through securities.
• Many MBS securities have prepayment risk, particularly those issued in the U.S. bond market and a portion of those issued in the Canadian market. This is due to the nature of the residential mortgage that form part of the pools of mortgages that underlie the MBS.
• The security backing the mortgage is residential properties (single-family, multi-family and social housing) fully insured as to interest, principal and timely payment by CMHC.
• NHA MBSs can be structured with an open or a closed pool. Because mortgages may have provisions for prepayment, which have significant effects on the cash flows and yields, MBSs are composed separately of pre-payable (open) and non-pre-payable (closed) mortgages.