Principal Protected Notes (PPN) all have exposure to some stock market indices, commodities or a basket of stocks. to obtain this exposure a portion of the PPN’s capital must be invested in either the these underlying investments or derivatives connected with these underlying investments. These investments are made with certain expectations for their individual future performance, but if they do not perform as expected and their values decline so much that it becomes questionable whether or not the investor’s principal can be returned to them, then the principal guarantee would be threatened. To avoid this risk, the PPN’s structure will include a clause called a Protection Event or Knock-out Scenario.
According to the Investment Industry regulatory Organization of Canada (IIROC),
The value of a PPN, although a debt instrument, is expressed in units represented by a net asset value or NAV. A typical debt instrument is normally expressed in terms of its face value with a coupon or interest rate. The term NAV is most commonly used in relation to mutual funds.
The NAV of the PPN can be affected significantly by volatility in the value of the investment portfolio assets. Safety strategies are built into the product structure of the notes to guard against this. If the NAV of the PPN hits a trigger, often when the cost of protection is equal to the NAV of the PPN, a reallocation of the holdings occurs. When such a reallocation action occurs, known as a “knock-out scenario” or a “Protection Event”, then the PPN becomes “monetized.”
Monetized Notes no longer carry any exposure to other underlying investments and will deliver minimal or no return on investment. Return of capital is still guaranteed, but only if the notes are held to maturity.