Principal Protected Notes

1. Principal Protected Notes Presented by: Stephanie Monsen, CIM, FMA, FCSI August 2007 – Advocis Banff School

2. Agenda – Principal Protected Notes • Introduction • What are Principal Protected Notes (PPNs)? • Examination of the current PPN landscape • Industry Trends & New Recommendations • How do PPNs work? • Guarantee – Explained • Other Features – Basic PPN Anatomy • Evaluating PPNs • Benefits & Risks • Client Suitability • Best Practices

3. What is a Principal Protected Note? Definition: A Principal Protected Note (PPN) is a debt instrument issued by a creditworthy issuer whose return linked to the performance of another investment known as the underlying asset. The principal is protected in the sense that the note is a direct, unconditional obligation of a creditworthy issuer; usually a Canadian or Global Bank.

4. Principal Protected Notes - Purpose • PPNs are designed to give the investor a guarantee of principal (typically provided by a Canadian or Global bank) and often currency protection along with the potential for reasonable returns. • All PPNs are purchased by investors with the intention of exceeding the current GIC rates of return. The returns for PPNs are generally linked to the performance of equities, indices, mutual funds, commodities or alternative investment products.

5. A Picture Is Worth a Thousand Words…. Variable Return Based on Index Growth in investment to provide Return Selling Commission Return Of Principal Investment Amount $100 Returned $100 Invested Growth in real or theoretical Zero Coupon Bond to return Principal Principal Protection

6. Principal Protected Notes Recap: • Bank Deposit Notes • Offering performance linked to a variety of investments • 100% principal protection • Potential for enhanced income and or growth through leveraging

7. Risk and the Financial Landscape ** When PPNs are not held to maturity, the risk profile for each note is uniquely dependent on the underlying basket of investments. Clients must understand that they can lose some of their principal if they do not hold the investment to maturity.

8. Principal Protected Notes: Market Overview • As of June 30, 2006 there were 657 PPNs issued in Canada • PPNs are gaining significant popularity and momentum in today’s market place. The majority of the PPNs have been sold through the IDA firms.

9. Principal Protected Notes & The Insurance Industry Past Trends: • PPNs were available through Referral Agreements with MGAs and their agents. Current Trend: • The Majority of PPN Providers only distribute PPNs through FundServ. This has made a Mutual Fund License a requirement for Advisors to sell these products. • This change can be directly attributed to the Industry’s reaction to Portus Alternative Asset Management’s recent situation.

10. Principal Protected Note Basics I • PPNs are fixed income investments with Information Statements that function like a Prospectus • Most PPNs are closed end investments offered for a brief selling period of anywhere from 6 to 12 weeks • Maturities vary from 3 to 10 years • Very few PPNs are CDIC insured while most are not. • PPNs do have a Cost Associated (Fee) • PPNs are usually sold as DSC products • PPNs are sometimes sold with an Intrinsic Front Load

11. Principal Protected Note Basics II • PPNs can be either Passive or Actively Managed • Actively Managed PPNs pay a trailer fee • Actively Managed PPNs charge an ongoing management fee • Ongoing management fees apply to leveraged amounts for Actively Managed PPNs • Passive PPNs do not pay a trailer fee • Some PPNs pay an income stream during the investment, others do not. • PPN income stream tax status varies

12. Principal Protected Note Anatomy I Investment exposure Virtually any basket or combination of securities, investment funds, market indices or commodity price movements. Lock in of gains A special feature, offered by very few PPNs. Minimum Return A few products provide a minimum return. Cap on return Yes, in addition to the existence of call feature. Callable Variable – some instruments can be called by issuer at certain return thresholds. Frequency of Pricing Variable, with some reporting net asset value daily. Redemption Rights There may be redemption rights prior to maturity at NAV subject to early redemption charges. Secondary market Depends on manufacturer.

13. Principal Protected Note Anatomy II Offering period Typically limited 4-12 weeks. Term/maturity Typically six to 10 years. It can be as little as 2.5 years or as long as 14 years. Minimum Investment Typically $5,000 ($100/contract x 50 contracts). Up-front commission Yes – either negotiated between client and advisor (1%-3%) or paid by manager in the case of a deferred sales charge option. Deferred Sales charge Sometimes – sliding scale over time, paid by client to firm. Trailing commission Sometimes as disclosed in information statement. Management fees Explicitly disclosed in information sheet when charged. Expenses Yes – additional to management fees.

14. Principal Protected Note Anatomy III Taxation Ongoing Distributions paid out to unit holders and taxed in their hands according to the nature of distribution. No tax if considered return on principal. Capital losses Possibility of being treated as capital loss and off-setting against other capital gains (depending on cost base and timing of redemption relative to announced payout.) Redemption prior to maturity Possibility of being treated as capital gains (depending on cost base and timing of redemption relative to announced payout.) Redemption at maturity Possibility of being treated as capital gains (depending on cost base and timing of redemption relative to announced payout). Upon death of annuitant Depending upon timing relative to announced payout, gain treated as capital gain or income for estate. Protection on Deposit Generally none, but for instruments with terms of five years or less, issuer may apply for coverage.

15. PPN Guarantee – A Tale of Two Structures • Options Based Strategy • Zero Coupon Bond + Call Option • Constant Proportion Portfolio Insurance (CPPI)

16. Option-Based Principal Protection Strategy • Traditional Strip Bond & Derivative Structure • Similar to Index Linked GIC strategies • Issuer used 65% to 70% of the proceeds of an offering to physically purchase a zero-coupon (strip) bond to cover the 100% Principal Protection Guarantee at maturity. • The remaining 30% to 35% of the note’s proceeds are used to write embedded call options on the underlying investment that the note is linked to in order to enhance returns. This is sometimes leveraged to provide close to 100% level of participation.

17. Option-Based Principal Protection Strategy • Facilitates easy calculation of investment returns at maturity • NAV is highly sensitive to movements in interest rates resulting from the significant investment in strip bonds • Worst Case Scenario: The underlying investment basket does not perform and the investor receives their principal back at maturity plus any specified interest amount guaranteed in the Information Statement.

18. A Picture – Option – Based Structure

19. Constant Proportion Portfolio Insurance (CPPI) Principal Protection Strategy • Also known as Dynamic Asset Allocation • This is an asset allocation strategy between a risky asset (underlying investment basket) and a risk free asset (zero coupon bond). The allocation is based on a formula that varies the weighting of each investment based on its current performance. • Uses dynamic hedging to keep the volatility of the underlying basket of securities as low as possible. • Allows leveraging (Up to 200% in some cases)

20. Constant Proportion Portfolio Insurance (CPPI) Principal Protection Strategy • NAV is generally unaffected by rising interest rates • NAV can be significantly affected by extreme or unprecedented volatility in the underlying basket of securities (both up & down) • De-gearing and Safety Mechanisms can be triggered and significantly affect the rate of return. • Worst Case Scenario – If nearly all of the trading capital has been lost, fund fees become set to zero and the entire investment is put into Government Bonds. Investors will end up with a minimal rate of return, often ½ % to 1% per year for the duration of the investment. This will be significantly lower than what could have been achieved with a GIC investment.

21. A Picture – CPPI Based Structures

22. Secondary Markets for PPNs • Generally PPNs are saleable once a secondary market exists. • Some have daily, weekly or monthly liquidity. • Most have a blackout period ranging from 6 to 18 months during which a secondary market has not yet been established. • If a note is sold prior to maturity in the secondary market any gains are usually treated as capital gains. • If a note is held to maturity any gains are usually treated as interest income. • Some issuers may have a call feature on the note to redeem it when it reaches a certain value by a specific date. The investor receives the callable return.

23. PPN Fees Explained PPN managers decide the amount and kind of fee to charge. Types of fees that some PPN manages charge are: • Selling commissions • Management Fees • Performance Fees • Structuring Fees • Operating Fees • Trailer Fees • Early Redemption Fees • Swap Arrangement Fees These fees will decrease the rate of return on the investment. If the total fees on a PPN are substantial, investors risk making far less on the investment than expected. *It is very important to understand how much money is used to pay all of the associated fees when evaluating a PPN for investment and what the expected rate of return will be net of fees.

24. Understanding & Evaluating PPNsKeys to the Information Statement * It is very important that an Advisor scrutinize the entire Information Statement before making a recommendation to their clients. The Information Statement fulfills the same legal requirement for PPNs that a Prospectus does for Mutual Funds. As a result a copy of the Information Statement should be provided to investors at the time of the investment.

25. Adobe Acrobat Tips for Quick Navigation and Referencing of PPN Information Statements Ctrl “f” = Find

26. Principal Protected Note Provider & Guarantor Company Questions: It is very important to evaluate the PPN Provider and Guarantor with your own due diligence on the firm. Some great questions to start with are suggested below: • Provide a brief history of the company? • What is the legal structure of the company? • What is the current ownership structure of the company? What if any changes have occurred to the ownership structure of the company in the last 3 years? • How many permanent employees does the company have? • How many permanent employees have 5 years or more tenure with the company? • If necessary, explain any significant employee turnover. • What has been the growth of the Assets Under Management over the past 5 years? • Is the company involved in any other business than investment management?

27. Principal Protected Note Advisor Questions to Ask Part I • What is the total cost (total fee) to my client? • Who is providing the Principal Protection? • Who is the guarantor? • What type of guarantee is it? CPPI (Dynamic Allocation) or the traditional strip bond & options? • Is it a DSC Note or an Intrinsic Front Load Note? • What are the terms of the DSC or Intrinsic Front Load? • Describe the Fixed coupon. (pay date, amount, tax status) • Describe the Variable coupon. (pay date, calculation, underlying securities, minimum/maximum payment & tax status)

28. Principal Protected Note Advisor Questions to Ask Part 2 • Based on the back testing data what was the probability of a zero coupon payment on each of the variable coupon dates? (This will provide an approximation of the likelihood that the client may not receive a coupon if the product is designed to pay an income stream prior to maturity.) • What was the average annual rate of return for the back testing? What was the range of the payout on each variable coupon? • Are there any special features? (Reset or Lock-In)

29. Principal Protected Note Advisor Questions to Ask Part 3 • What will the investment look like on my client’s statement? Will the Market Price or NAV fluctuate? • What is the reporting policy? (Frequency, Quality and Level of Transparency) • How does the secondary market work? What are the cut-off times/days for orders to be processed? What is the procedure to sell on the secondary market? • Is a secondary market guaranteed? • When does the secondary market start? What is the hold period? • How is the Market Value for the Secondary Price calculated? Will my client receive that amount? (Are there any additional transaction fees?)

30. Principal Protected Note Advisor Questions to Ask Part 4 • How is leverage applied to the PPN? What is the minimum? What is the Maximum? How are fees applied to the leveraged amount? • For CPPI Guarantees, at what point does the PPN go into Principal Protection Mode and collapse the Investment Basket to bonds? • What is the Worst Case Scenario? • What level of communication and service can be expected from the company and the Wholesaler? • Is the product on FundServ?

31. The Principal Protected Note Investor Principal Protected Notes have become very popular among investors looking to limit downside risk while still having the opportunity to participate in potential stock market gains. Here are some typical investor profiles: • those who would like the opportunity to make equity gains but are concerned about market volatility • the traditional GIC investor looking to retain capital protection while enhancing yield • high net worth investors seeking wealth protection accompanied by steady growth • segregated fund investors with shorter investment time horizons who want to protect their invested capital

32. PPN Benefits & Considerations Access to a wider variety of risk-reward profiles • Basis of calculation of variable return • Participation rate • Minimum return • Coupon Access to more products • Fund of Hedge Funds • Diversification • Commodities Tax Benefit Security

33. Selling PPNs – Sample Advisor Checklist • Client Suitability - Risk Profile similar to Seg-fund with same mandate has been met. • Client has been provided with a copy of Information Statement & recorded in file for any E & O issues that may arise in the future. (e-mail is great for this) • Client understands the length of the investment i.e.) 8 to 10 years. • Client understands guarantee is only for their principal at maturity. In acknowledging this the client is aware that they can lose the guarantee on their principal and be charged a fee if they take out their money early.

34. Risk & Other PPN Issues • Credit • Investment • Timing • Liquidity • Inflation • Hedge Counterparty • Interest Rate • Lack of Transparency of Pricing, Fees and Expenses • Risk of Reduced Investment Exposure • Path Dependency of Returns • Possible Redundancy of Principal Protection

35. PPN – Investment Risks Risk • Credit: Risk of loss to the investor if the issuer of the PPN fails to repay the principal and pay the return. • Investment: The risk that the investor will not get a return because of a poor performance of the underlying asset. • Timing: The risk that the PPN will mature when the underlying asset has just been impacted by a reduction in the market price. Reducing or eliminating the return. • Liquidity: The risk of loss from the inability to sell the PPN and get the initial investment back prior to maturity. Not all PPNs have a secondary market. How to Assess • Credit risk is managed by purchasing PPNs issued by creditworthy issuers, as evidenced by their credit rating. • Manage investment risk by subjecting the underlying asset to the same kind of analysis that you would perform before recommending an investment generally. • There are products which avoid timing risk, but at a price • Three forms of liquidity may exist • A stock exchange listing • Redemption rights • A dealer-maintained secondary market

36. PPN Considerations Lack Of Transparency Of Pricing • Unlike mutual funds, some costs are embedded in the price of the product Fees and Expenses • Hedging profit embedded in the price of the product • Sales charges • Annual fees and expenses (How many layers?) • When the underlying asset is a fund, two layers of fees exist. With a fund of hedge funds, there are multiple layers of fees and expenses exist.

37. Client Suitability Considerations

38. Client Suitability Considerations II

39. Risk Tolerance & Client Suitability • Each firm and Advisor should develop their own policy for determination of appropriate risk profiles for investors in PPNs. • This is a Sophisticated investment vehicle • Issuer quality needs to be understood • Opportunity for enhanced returns needs to be clarified, possibility of return not meeting expectations must be understood • Liquidity issues, redemption fees, above average commissions

40. New Industry Best Practice Recommendations for Client Suitability May 2007 – IDA issues Due Diligence Guidelines. Upon review, many IDA firms now require: • Minimum level of investment knowledge should be at least “good” or higher • Minimum risk tolerance should be at least “Medium or High” • There are many considerations when developing an investment plan for a client, and giving appropriate advice. These are offered merely as introductory guidance on possible means of determining the appropriateness of a PPN recommendation in general

41. Selling PPNs – Sample Advisor Checklist I • Client Suitability - Risk Profile - new IDA recommendations met or risk profile requirement similar to that of a Seg-fund with same mandate has been met. • Client has been provided with a copy of Information Statement & recorded in file for any E & O issues that may arise in the future. (e-mail is great for this) • Client understands the length of the investment i.e.) 8 to 10 years. • Client understands guarantee is only for their principal at maturity. In acknowledging this the client is aware that they can lose the guarantee on their principal and be charged a fee if they take out their money early.

42. Selling PPNs – Sample Advisor Checklist II • Client understands the Fees. (DSC, Agent Fee, Total Management Fee, Redemption Fees and Spread on Secondary Market) • Client understands the holding period and acknowledges it in writing. • Client understands the secondary market is not guaranteed. • Client understands that the NAV will fluctuate similar to a Mutual Fund. This is the value that they will see on their statements. • Client understands the ‘Worst Case Scenario’ and what its impact would be on their portfolio.

43. The End Thank you & Questions???