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Finally, realism is a part of protected-note fairytale

The free ride is over for one of the worst investment products out there right now.

The federal government has just issued a set of proposed new rules that would require issuers of principal-protected notes to do a better job of disclosing fees and helping investors understand what they're buying. The proposals aren't quite as tough as they might be. But they are an improvement on the status quo, which allows financial firms to peddle the fairytale that successfully investing in the stock markets with zero risk is as easy as buying a PPN.

The new federal rules are open to comment right now, but they're expected to be finalized and in place by April 1. Securities regulation is normally handled by the provinces, but PPNs are primarily issued by federally regulated banks.

PPNs allow you to buy into assets like mutual funds, baskets of stocks and stock indexes, commodities and hedge funds with a bank-backed promise that you'll do no worse after a term ranging from five to 10 years than get your original investment back. There are lots of ways to invest conservatively without all the costs and restrictions of PPNs, and without the risk of tying your money up for years and ending up with no gains at all. Still, there's no question this is a product that speaks to risk-averse people.

The amount of money invested in PPNs has grown this decade from virtually nothing to $21-billion by the latest estimate from research firm Investor Economics. The number of PPN issues in the marketplace has in the past four years grown tenfold to a preliminary estimate of 1,135 as of September.

Ottawa's regulations fall short of doing what needs to be done with PPNs, which is to require that they meet the same simple but comprehensive disclosure standards as mutual funds. But the new rules do address some key areas where PPN issuers aren't uniformly delivering what investors need to know.

The first area is fees. The new federal rules don't say exactly how PPN issuers are supposed to get the word out, but they are required to tell buyers both orally and in writing about the fees involved, and how they will affect returns.

The rules would also require issuers to say whether a PPN can be redeemed before maturity (they usually can), and whether the principal guarantee would apply in that case (it usually won't). There would also have to be details on the secondary market for a PPN issue, which means the mechanics of how you'd sell before maturity. Presumably, investors would be told whether they would receive a decent bid for their notes if they wanted to sell, or if they would have to take a major haircut.

Other requirements under the proposed federal rules include the following:

PPN issuers would have to make information available to clients on the net asset value of their note on a given day, and the value of the underlying investments.

Before an investor sells before redemption, issuers must provide in writing the amount of principal and interest payable, and any penalties for selling early.

The way in which gains are calculated must be clearly shown, and any limitations on these gains must be spelled out.

The proposed federal regulations would apply only to PPNs issued by banks, which are estimated to hold about 80 to 90 per cent of the market. An official with the Ontario Securities Commission said yesterday that the federal rules will adequately cover the PPN market.

Financial firms have been known to fight new regulations bitterly, but Ottawa's PPN rules seem to be in good shape. The Canadian Bankers Association, the lobby group for the banks, said yesterday that it's generally comfortable with the approach Ottawa is taking. The group also indicated its approval of the government's approach of trying to enhance disclosure without being too prescriptive in terms of telling the banks what to do.

Ironically, PPNs are just the sort of thing where a prescriptive approach is called for. The whole concept of PPNs speaks to their appeal to unsophisticated investors who need not only disclosure but simple disclosure they can understand.

That's what you get with the simplified prospectuses issued by mutual fund companies - they tell you all the various costs of buying and owning their products in a standardized way, and they provide examples in dollars and cents.

The CBA said banks have already begun improving their PPN disclosure and, to be fair, the presentation is better in some cases than it used to be. The investment industry can do better on PPN disclosure, though. Ideally, there would be enough information to persuade thinking investors to avoid PPNs and get their conservative market exposure the old-fashioned way. In case anyone's forgotten, that means building a diversified portfolio with bonds, cash and blue-chip dividend stocks.

PPNs by the numbers

Here's how a selection of principal-protected notes issued by Canadian Imperial Bank of Commerce have fared.

Note namedatedatereturn*
BDC Global Stock Index OPaLTMOct. 9/'02Oct. 9/'08+ 10.50%
Notes, Series 1
CIBC American Blue Chip OPaLTMDec. 25/'02Dec. 27/'07+ 4.83%
Deposit Notes, Series 1
CIBC American Premium PEaRLTMMarch 22/'04March 18/'11+ 1.97%
Deposit Notes, Series 1
CIBC Asia-Pacific Index DepositJune 28/'06June 28/'11+ 19.41%
Notes, Series 1
CIBC Blue-Chip Guaranteed GrowthDec. 16/'05Dec. 16/'10- 0.68%
Deposit Notes, Series 1
CIBC Blue-Chip Rainbow DepositMay 3/'06May 3/'12+ 1.67%
Notes, Series 1

* Includes distributions


© 2007 The Globe and Mail. All rights reserved.

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