One thing we have been strategically adding to portfolios recently is a product called a Principal-at-risk note. Here is our justification for why.

1 – First, some basic details about principal-at-risk notes

Principal-at-risk notes (PARNs) pay a coupon throughout the entirety of a year. That payment can be monthly, quarterly, semi-annually, etc. But that payment is fixed both in timing and in amount. Now there are some details we can’t just gloss over that surround that payment. With a principal-at-risk note, investors are only going to receive that payment if the underlying securities stay within a range. For this example, let’s use a principal-at-risk note paying 12% per year, paid quarterly, as long as the underlying securities stay within the range of 25% on the downside and 10% on the upside. Should the note last until maturity, let’s assume a term of 5 years.

So let’s unpack this.

First, the underlying securities. For this example we’ll use some big names in Tech, namely Amazon, AMD, Meta, Microsoft and nVidia. The performance of these 5 stocks, averaged equally, will be the measure by which the note is valued. Like a bond, this PARN will be issued at $100 and will move up or down based on the average movement of the 5 stocks. So if AMZN, AMD and Meta are all up 1% on a given day and MSFT and NVDA are both down 1% on a given day, the price of the PARN will move up by 0.2% to $100.02. This daily calculated price is what is monitored on the scheduled payment dates to ensure it remains inside that -25% to 10% range.

The daily calculation of the price of the note combined with the -25% to 10% range is important because it determins whether the payment that the investor purchased the note to receive is actually going to be received. That is because if the price of the note slips to below $75, the quarterly 3% payment is not made to the investor as it falls outside of the payment range. On the upside, if the note has moved to above $110, the note is “called away” and the investor will receive their principal back along with some, or all, of the pricipal appreciation to $110. If the note has moved to $120, the investor will receive a maximum of $10 appreciation as the upside is capped at 10%. Keep in mind that these price ranges are only observed on a date of payment. So if the note was $108 or $77 on the date a quarterly payment was supposed to be made, the investor receives the 3% payment. The next day, the note price could rise, or fall, to over $110 or under $75 and it would not affect a future payment or be called away. The only time the price matters is on the date of payments.

Lastly, the bottom part of the range is important for the day the note matures. In our example, it is 5 years out from today. So in 5 years, the investor is considering two things when it comes to that 75% downside threshhold. They are wondering if they will be receiving their final 3% payment and how much of their principal they will receive back. That is because if the note matures at a price lower than $75, only that amount is paid back to the investor. So, if on the final payment date of the note, the note is priced at $74.99, the investor, who invested $10,000 into the note on Day 1 will only receive $7,499 of their principal back. If the note matures anywhere above $75, the investor receives their full principal ($10,000) back in combination with however many 3% payments they received over the course of the life of the note. Now that we have gone over the basics of their PARNs, let’s get into some of the reasons we feel they are a good investment for the current market we’re in.

2 – In a market that can’t decide if it’s up or down….let’s try to find some consistency

The markets can’t seem to decide if they’re up or down as we enter the 2nd quarter. After a hot start to the year, things already cooled and rebounded again. Our thinking is, that with so many questions marks concerning equity as we move forward, let’s try to find some fixed return.

As we described above, the PAR note is paying us 12% a year as long as the average of the 5 underlying stocks are not down over 25%. So, let’s assuming a flat market by years end. The portion of your portfolio allotted to these PAR notes is significantly outperforming that stagnant market.

3 – Hedge Stocks We Already Own

Another aspect of these PAR notes is that they also represent a hedge against stocks we already own. One of our core holdings is Microsoft. It has been a great performer and we have never clicked the sell button on Microsoft for any reason, outside of re-balancing. But Microsoft, like any other stock can experience volatility and holding a note with Microsoft as one of the underlying stocks allows us to not only collect the dividend income from Microsoft, but the 12% the note offers even if Microsoft falls 15% in the remainder of the year.

It’s also important to own one of the underlying stocks to ensure we participate in the upside as well. As mentioned earlier, the note is capped at a 10% upside, meaning if the underlying stocks move on average to above $110 on a payment date, the note is called away, the investors principal returned and obviously, no further quarterly payments are made. So we want to ensure that we are not missing out on the potential upside. Holding at least as many dollars in Microsoft stock as we hold in the PAR note allows us to hedge the downside to 12% and take full advantage of the upside should the stock market rally and have another year like 2021.

4 – Memory

Last, but certainly not least, is the memory feature of the note we use. This might be the most important aspect of these notes. The notes we are putting into portfolios all come with a memory feature. This is in relation to that -25% threshold that decides if we receive our quarterly 3% payment or not. The memory rider states that on a payment date, when the note has fallen below that 25% threshold, any missed payment will be noted and immediately paid out on the next payment date when the average of the 5 stocks has risen back above the 25% threshold.

So, in a worst case scenario, let’s pretend that we miss receiving every 3% payment from the inception of the note until the second-to-last payment date. Then, on the final payment date, the 5 underlying stocks “recover” to being down 24.99%. this means that all the missed quarterly payments will be made to the investor and their principal returned in full.

In short, in 5 years time, as long as Amazon, AMD, Microsoft, Meta and nVidia are not down, on average, by 25%, the investor will receive all their 3% quarterly payments as well as their principal reagrdless of how the stocks performed during the life of the note.

So while these notes are not a traditional asset, we do believe they have a place in a market where sentiment is mixed, at best. We can choose the details of the note, from industry to underlying securities and time to matury.

We will continue to explore any avenue that we think will bring meaningful performance to your portfolio in uncertain times. If you have any further questions, please feel free to reach out.

This information has been prepared by James Hogan who is an Investment Advisor/Portfolio Manager for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor/Portfolio Manager can open accounts only in the provinces in which they are registered.

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.