The Globe and Mail

For a supposedly safe investment, there sure are a lot of risks associated with principal-protected notes.

Tax changes being considered by the Canada Revenue Agency could, in the words of one issuer of principal-protected notes (PPNs), “have a material adverse effect” on these investments. And then there's the experience of the U.S. investors who hold PPNs issued by the once illustrious but now bankrupt Lehman Brothers. They're waiting in line to get paid along with other creditors.

PPNs offer a way to invest in stocks, commodities, mutual funds and hedge funds without the risk of losing money in the end. But even this protection of your initial investment entails some risk.

Just recently, terrible financial market conditions have forced some PPNs into a kind of survival mode so they can pay back investors at maturity. These PPNs may have years to go until they come due, but investors are only going to break even (and that's not taking inflation into account).

Let's call this a loss-of-opportunity risk. Instead of making zero in a PPN, you could have nailed down returns of 3 to 5 per cent annually in a guaranteed investment certificate.

You'll know about the tax risk associated with PPNs if you read deep into the Risk Factors section of the information sheets prepared for recently issued notes (like anyone ever does this). In one particular case, there's a mention of a review by the Canada Revenue Agency (CRA) that could change the way PPNs are taxed in non-registered accounts.

Currently, PPN holders pay taxes on any gain they realize when their notes mature, usually after three to 10 years. The change under consideration could require investors to pay taxes on any gains on an annual basis.

The CRA wouldn't comment on the review. But tax expert Paul Hickey of the accounting firm KPMG said the key issue for agency is that it's possible to buy and sell PPNs before they mature on what's called a secondary market. If a value can be put on a PPN for the purpose of selling it before maturity, the same value can be used to determine whether a theoretical taxable gain applies.

“As the CRA has become aware that there is a secondary market on which investors may sell these notes, it is now proposing that the pricing on the secondary market be used to determine an annual interest accrual amount to an investor for tax purposes,” Mr. Hickey wrote in an e-mail. In other words, investors may have to report gains on their PPNs on an annual basis and pay taxes where applicable.

If the CRA goes ahead with this change, and there's no certainty it will, then PPNs would be lumped in with strip bonds on the list of investments that are best held in registered accounts. Strips are bought at a discount to the value at which they'll be redeemed on maturity. You won't receive semi-annual interest payments like you do with a regular bond, but the CRA still wants you to compute yearly interest income for non-registered accounts.

Typically, PPNs protect you from losses by investing much of their assets in bonds and a lesser amount in stocks, funds and such. The bonds should generate sufficient returns to cushion the loss of the entire investment in riskier securities.

Another level of security comes from the fact that the principal protection offered by a PPN is underwritten by the banks and insurers that issue these products. This brings us to the issue of credit risk, which means that a PPN's capital guarantee is as strong as the financial company providing it.

Here in Canada, where the financial sector is considered among the world's strongest, these guarantees offer some reassurance. But U.S. investors probably thought the same of PPNs issued by Lehman, a Wall Street fixture before collapsing last month as the global financial crisis reached a peak.

The worst news for PPN holders in Canada lately is that some notes issuers have declared what's known as a “protection event.” These PPNs are dead money – their guarantees will apply, but the opportunity to make any profit is gone.

A protection event is even more of a blow in the case of PPNs that were designed to pay income as well as offer the potential for capital appreciation. Take the RBC IA Clarington Global Dividend Deposit Note Series 1, for example. Issued in May, 2007, this PPN series stopped making monthly payouts this past July when a protection event was triggered.

There are PPNs issued in the past few years that have made money for investors by investing in commodities, stocks and other things. For the lucky investors who hold them, PPNs have provided a conservative way to get into the markets.

But PPNs aren't going to be thought of like that in the future. Instead, they'll be mentioned as an example of how much value there is in the old saying that there's no such thing as a risk-free investment.