IDA offers due diligence guidance on PPNs

Well, better late than never. The IDA has published a guidance document on the assessment of principal-protected notes, aimed at helping advisors understand the suitability of these investments for their clients.

The IDA’s Due Diligence Guidelines on Principal-Protected Notes, a rather hefty document at 72 pages, offers an explanation of how PPNs are constructed, how they work and how to evaluate them.

“Perhaps the greatest benefit of PPNs to the investor relates to their flexibility,” the document states. “This flexibility enables the investor to enjoy risk-return characteristics which are not possible with other investments.”

PPNs have been on the market for years, receiving little criticism at first because of their perceived safety. But lately there has been growing dissent, questioning whether a guarantee on the principal was enough to justify the costs. The lack of transparency on just what those costs are raised even more concerns.

These issues form the basis of the two primary questions the advisor — or the firm — needs to answer in due diligence investigations:

• How complete and of what quality is the product disclosure?
• What is the size of the costs, if any, embedded in the price of the product?

But due diligence on PPNs should go beyond the associated costs and quality of disclosure, according to the IDA guide. The issuer of the note should also be evaluated. Most often these are Schedule I or Schedule II banks, which are typically able to offer the notes under the exemption for trade in debt securities and guaranteed investments — essentially, the regulators view them as GICs.

There is still room for regulatory risk, however, as the notes must satisfy the requirements of the exemption.

It is also important to understand what the issuer stands to gain from these products. Not only does it stand to earn a profit from the associated costs of the investment, but the issuer is essentially borrowing capital from the investor at a lower-than-market rate.

“Think of the zero-coupon bond as being issued by the same entity that issues the PPN. The issuer uses the proceeds of issue of the zero-coupon bond for general corporate purposes,” the IDA guide explains. “At maturity, it will repay the face value of the zero-coupon bond from its own funds. In effect, the issuer has borrowed money at the rate of interest used to calculate the price of the zero-coupon bond.

“In light of its target borrowing cost, the issuer will negotiate with the product structurer a rate of interest lower than that on a conventional debt instrument. The reduction in the issuer’s borrowing cost is ultimately borne by the investor.”

The creditworthiness of the guarantor presents the greatest risk to the investor, however. Should that firm fail at some point prior to the note’s maturity, it is questionable how much the investor would recover. Fortunately, the majority of PPNs are issued, as mentioned already, by Schedule I banks, and the odds are strongly against a collapse. In the case of Schedule II subsidiaries of foreign banks, it is the credit rating of the foreign parent that should be considered, the IDA says.

Some PPNs may be issued by institutions with credit ratings below investment grade, however, and these are the ones that require closer scrutiny. Worse yet, regulators do not require the disclosure of the credit rating on the information statement.

“Although an issuer’s credit rating is public information, it is not always disclosed in the PPN’s information statement,” the IDA points out. “For instance, the information statement of an actual PPN issued by an issuer with a ‘BBB’ rating makes no mention at all of the issuer’s credit rating.”

The guidance document goes on to explore the due diligence issues around the PPN structurer, how to assess a note based on the underlying investment, and the risks associated with the structure of the note itself, including issues of liquidity.

Finally, the guideline document addresses the issues of fees, and the tax implications of the notes.

Before selling a PPN, the advisor must be aware of how gains will be treated for tax purposes. Is the note structured in such a way that returns come in the form of capital gains, interest or a return of capital? Does the tax consequence of the return’s structure outweigh the benefit of principal protection?

The IDA guideline document offers an example:

“Consider the case of a PPN whose underlying asset is a portfolio consisting of dividend-paying stocks. Suppose that the PPN pays monthly coupons equal to some percentage of the dividends paid by the stocks in the portfolio. Depending on whether the monthly coupons constitute interest or return of capital, they will be taxed in the hands of the investor as interest or [will] decrease the adjusted cost base of the investment. If the investor had invested directly in the stocks, the receipts would have been taxed as dividends.”

For most advisors, the due diligence process will take place by committee at the head office of their firms. But even though the dealer has approved the product for sale, the advisor will always have to assess the legitimacy of placing a client’s assets in any given investment.

To download the full guideline document from the IDA website, please click here.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(05/07/07)

Steven Lamb