I really enjoy meeting new clients and helping them navigate through the world of finance, which is why I thoroughly enjoy meeting new clients. Each client brings with them interesting questions and last week, I met with a couple that was particularly interested in principal protected notes (PPN).The client had been hearing about them from another advisor in town who they have been working with, and was wondering about our opinion  here at Retire First.

The selling point of PPN is that they are guaranteed to return your principal investment after a certain number of years, additionally there is also the possibility that you can make a better return through their exposure to the market. PPN investing philosophy is complex, using options and derivatives that are lost on the average investor. So why would investors want to participate in something they don’t understand? Its hard to say no to the idea of no risk, all the reward that PPN are built on.

It may sound too good to be true, and it is. First of all when PPN guarantees are paid back after the note matures years down the road, the principal is actually worth less, since the PPN guarantee does not adjust for inflation, eroding the principal purchasing power. Additionally, there are fees involved. Big fees. Typically, PPN fee’s fall into the range of 3-5%! These fees require equate to large account gains that are necessary to even recoup before they broke even, significantly limiting your upside potential.

Worse yet, your friends who were flaunting their PPN, during the market down turn last year got another surprise, when their PPN went into protection mode. As many PPN holders found out, protection mode meant that investors will get their principal back, and nothing more, when the notes mature years from now, even if their notes follow the market rebound. That principal of course, will have less buying power because of inflation. That 1year 1.35% GIC rate is sounding pretty good right now, isn’t it?

So what does the investor who likes the sounds of the PPN, still wants market upside but hates the high fees, to do? You can build your own PPN, by following the simple concept below, illustrating how to build a PPN with fictional portfolio of $1000.

One: Find a government strip bond that is maturing at the same time as the PPN that you are currently looking at. Strip bonds pay no interest; instead they sell at a discount to their face value, which the investor receives at maturity. For simplicity sakes, let’s assume that the strip bond can be bought for $900, and will maturity in 10 year at $1000.

Two: After buying the bond we have a $100, remaining from our $1000 we planned to invest. Take the one hundred dollars and invest it in the market in an ETF or an Index fund.

You have now created your own PPN, whose worst case scenario is that every single company in your ETF goes bankrupt and you lose your one hundred dollars, but you will still get $1000 back from your government strip bond. That is of course, assuming that the government will not default.  Instead, you could be collecting dividends from your ETF and market gains over the next 10 years, and paying fewer fees than your PPN buddies.

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