Are Principal Protected Notes a Good Investment?

In the current investment climate, where deposits are yielding zero (or negative), fixed income returns are negligible, and equities have been booming for the last 7 years – bringing them closer to a correction by the day, finding a safe investment that might outperform your average bond or deposit might be a bit of a nightmare.  Enter the Principal Protected Note.

A Principal Protected Note is a structured product; which, in its most basic form consists of a zero coupon bond and a call option on an equity or index, or pretty much any other asset class with variable return.

formulaeThis is how it works: Once the investment has been made, the issuer will take an
important part of the investment and purchase a zero coupon bond to match the life of the investment.  This is the part that provides the principal protection, since the zero coupon bond will mature at par.  Whatever is remaining of the investment minus the market price of the zero coupon will generate the manager fees, plus it will allow the purchase of a call option or a leap on the underlying for a notional value matching that of the initial purchase.  Some principal protected notes feature capped returns, meaning that should the returns be above a certain level, then the manager would pocket the excess returns.  Let’s look at an example:

$10,000 investment on a principal protected 5 year note linked to the return of the Dow Jones Industrial Average capped at 10% return.  The investor would give the manager $10,000.  The manager would then purchase a zero coupon bond at a discount, that will mature at par in 5 years.  With the remainder he will collect his fees, and purchase a call option on the DJI matching the maturity of the bond for a total notional of $10,000.  The payoffs are as follow:

  1. Out of the money option: The value of the DJI is lower in 5 years than it was at the time of the purchase, so the option expires worthless, the zero coupon bond matures at par, and the investor recovers his principal.
  2. In-the-money option where the return is between 0% and 10%: The investor will receive the value of the zero coupon bond at par, plus the full return of the option.
  3. In-the-money option where the return is over 10%: The investor will receive the value of the zero coupon bond at par, plus a 10% return .

Why is it a good idea and who are these notes designed for?

Principal protected notes give you a potential above market return with limited downside, so what is the catch?  Well, for starters the fees are huge, and in the case of the capped investments, the actual returns from the variable portion of the investment could exceed several times the cap.

You should look into investing in principal protected notes if you have very low risk tolerance i.e. your main goal is preservation of capital, yet you aren’t comfortable with making half a percent return, or worse yet paying someone for the privilege of lending them your money.  And you are willing to forego a potentially big return in exchange for having a limited downside.

Principal Protected Notes come in all shapes, sizes and flavors, make sure you are buying one that suits your investment profile.

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