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I was looking at principal protected notes (PPN) at a bank (link: CIBC Principal Protected Notes). It says:

  • The return of your CIBC PPN depends on the performance of the underlying assets. (It is possible that no interest may be payable)
  • Regardless of performance, your full principal amount will be repaid at maturity
  • Terms range from 3 to 8 years

Suppose I want a PPN. My question is: why should I buy one from a bank? What advantage do bank PPNs have over one that I create for myself?

As far as I am aware, I can create a PPN by:

  • Buying a high quality bond (e.g. government bond).
  • Using an amount equal to or less than the future coupon(s) from the bond to buy an at-the-money call option (e.g. LEAPS) on an index ETF.

With this arrangement, I cut out the middleman (i.e. the bank), I don't have to worry about the credit risk of the bank, and should I choose to, I will be able to liquidate the PPN at any time without having to wait for the "maturity".

Flux
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2 Answers2

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You are correct. Doing the PPN yourself eliminates the direct and indirect fees as well as avoiding the credit worthiness risk of the issuer and you control the time period of the 'investment'. One thing that you have to look out for with a CIBC PPN would be:

  • Some CIBC PPNs may also have caps, participation rates and/or other limiting features That's where the issuer really takes your money (The participation rate what percent of the gain in the underlying asset, index or benchmark will be earned).

FWIW, I got interested in Structured Index Annuities two years ago. For this product, the insurance company offered about a 10% cap per year along with 10% of downside protection on major indexes. Shortly thereafter I determined that I could replicate the product using options but by doing it myself, I could obtain closer to 20% downside protection for that same cap (a 1:2 ratio). The cap and DP ratio can be shifted by varying the strike price of the options chosen. I have been employing this strategy for the past two years but on a 3-5 month basis rather than one year out because the numbers annualize higher. Even more so now because option premiums are greatly inflated due to higher implied volatility levels.

This last point about higher premiums due to higher implied volatility levels would be a detriment to your strategy because the option component costs more now and with rates down, you'd be receiving less on your bond component.

Bob Baerker
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Are you sure that when you Long Call and Long Bond, your principal is Guaranteed?

Suppose your principal is $100, and you bought a 2-year ATM Call Option for $14, and a Bond for $86.

2 years later the stock did not move and you lost time value. The Call Option is not worth $14 anymore. Your principal is no longer $100.

On the other hand, your bank could guarantee that your principal is never below $100 (at the expense of capped gains of course).

Furthermore, LEAPS are usually up to 3 years only, far from 8 years.

base64
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