What Are Principal-Protected Notes (PPNs)?

Principal-protected notes (PPNs) are fixed-income securities that guarantee to return, at a minimum, all invested principal. This guarantee of the return of the initial investment is their distinguishinꦰg feature.

The names used to describe PPNs, or "notes," vary. In the U.S. market, they are called structured securities, structured products, or non-conventional investments. In Canada, they are known as equity-linked notes and market-linked notes—a type of guaranteed investment certificate (GIC). There are also structured investment products and 澳洲幸运5开奖号码历史查询:structured notes, which are similar to PPNs but w♌ithout a princꦜipal guarantee.

PPNs have the potential to obtain attractive returns given favorable market conditions. This article provides an overview of the risks and due diligence requirements associated with the purchase of a note. The sample calculations are for a note with an eight-year term, a sales commission of 4%, an annual inflation rate of 2%, and an annual interest rate of 5%. 澳洲幸运5开奖号码历史查询:Compounding occurs on an annual basis.

Regulation and Disclosure

Compared to stocks and bonds, notes are complex investments that contain embedded options, and their performance depends on the linked investment. These features can make the performance of a note difficult to determine and complicates its valuation.

Because of this, regulaﷺtors have expressed concerns that retail investors, particularly the less sophisticated ones, may not appreciate the risks associated with the purchase of a note. Regulators such as the (NASD) and Canadian Securities Administrators have also emphasized the need for due diligence, both on the part of the seller and the purchaser of a note.

Numerous Fees

A note is a managed-investment product and, as with all managed products, there are fees. It makes sense that the fees associated with a note will be greater than with a stock, bond, or mutual fund because the principal guarantee is really the purchase of insurance. The insurance premium is in effect the interest foregone by purchasing a note rather than interest-bearing security.

In addition to the insurance premium, there are numerous other explicit or implicit fees. These include selling 澳洲幸运5开奖号码历史查询:commissions, management fees, pe🐻rformance fees, structuring fees, operating fees, trailer fees, and early redemption fe♔es.

There is little need to focus on each fee, but knowing the total amount of money spent on fees is important because it will eat away at your potential return. Ironically, it is not always possible to know the total fee. For example, with a 澳洲幸运5开奖号码历史查询:commodity-linked note, based on a 澳洲幸运5开奖号码历史查询:constant proportion portfolio insu𒆙rance (CPPI) strategy, trading fee🍸s depend on the volatility of the commodity. This is one of the added complexities of investing with no🍌tes.

Numerous Risks

All investments come with exposure to risk. The risks associated with notes include interest rate risk, the risk of a zero return, fee risk, suitability risk, and liqui💦dity risk.

Interest Rate Risk

Interest rate changes can significantly affect the net asset value (NAV) of a note. For a note based on the 澳洲幸运5开奖号码历史查询:zero-coupon bond st꧒ructure, the interest rate in effect at the time of issue deဣtermines the cost of the insurance; that is, the zero-coupon bond.

For a note issued with an eight-year term, when the annual interest rate is 5%, the cost of the zero-coupon bond would be $67.68 per $100 of 澳洲幸运5开奖号码历史查询:face value, leaving $28.32 after a 4% commission ($100 - $4 - $67.68) to purchase options. Had the interest rate been 3%, the zero-coupon bond would cost $78.94 per $100 of face value, ༒lꦅeaving $17.06 after commission ($100 - $4 - $78.94) to purchase options. After the purchase of the zero-coupon bond occurs, changes in interest rates can affect the NAV of the note as the value of the zero-coupon bond changes.

Based on the CPPI structure, for a note, the effect of changing interest rates is more complex and is not dependent on the interest rate in effect at the time of issue. The cost of insurance depends on when the rate changes, how much the rate changes, and the effect of the rate change on the linked 澳洲幸运5开奖号码历史查询:underlying asset.

For example, if interest rates decline si💯gnificantly early in the term, the cost of a zero-coupon bond will increase, thereby reducing the cushion. If the interest rate increase also causes the value꧒ of the underlying asset to decrease, the cushion will suffer a further reduction.

Zero-Return Risk

The risk of a zero return is a loss of both 澳洲幸运5开奖号码历史查询:purchasing power and real returns. The magnitude of each depends on the difference between the interest rate and the average inflation rate👍 that prevails during the term of the note. To maintain purchasing power when inflation is 2% annually, an investment of $100 must grow to $117.17 by the end of eight years, assuming annual compounding. A $100 investment receiving a 5% rate of interest would grow to $147.75 in eight years. In this example, the investor realizes a nominal return of $47.75. However, the real return is only $30.58 ($147.75 – $117.17 = $30.58)✨.

But if the rate of inflation averages 3% over the eight-year term, a return of $126.68 is required to maintain purchasing powerౠ. The real return is only $21.07 with a nominal return of 5%. As shown by the calculations, a higher than expected inflation rate increases the purchasing power loss while decreasing the real return.

Fee Risk

Fee risk is the risk that the fees charged will be higher than expected, thereby reducing the return. The risk is most applicable to dynamically hedged notes; those using a CPPI strategy. Over time, cumulative trading costs will increase if the volatility of the linked asset increases. At the same time, the performance of the no🎃te is less likely to closely track the performance of its underlying, linked asset. This is one of the added complexities of a note.

Suitability and Liquidity Risk

Suitability risk is the risk that neither the advisor nor the investor sufficiently understands the structured product to determine its suitability for the investor. Liquidity risk is the risk of having to liquidate the note prior to the maturity date, likely at less than its NAV, due to a thin or absent 澳洲幸运5开奖号码历史查询:secondary market. With ea♔rly liquidation, there is no principal guaran🧜tee.

Other Risks

In most cases, notes are not suitable investments for income-oriented investors because there is only one payout, and it occurs at maturity. Furthermore, there is a risk of receiving no income and, at the same time, incurring a loss of purchasinওg power.

Potential Investment Scenarios

An investor may consider purchasing a note if they have a strong view that the asset linked to a note provides the opportunity to exceed the return available from a fixed-income investment. Provided the investor is comfortable with the risk of no return, purchasing a note provides exposure to this opportunity without the risk of losing 澳洲幸运5开奖号码历史查询:the investment principal.

An 澳洲幸运5开奖号码历史查询:unaccredited investor may purchase a note with a return linked to the return of an alternat🍌ive investment, such as a hedge fund, to bypass the regulatory restrictions limiting direct investment in alternative investments to accredited investors. This is possible because regulatory authorities view a note as a debt investment or a deposit.

A sophisticated investor, rather than directly taking a 澳洲幸运5开奖号码历史查询:speculative position, may use a note to gain exposure. Acting as a floor, the note provide🌠s downside protection, guarant⛎ees a minimum return, and protects the invested principal.

The Bottom Line

Notes are complex investments that require t♊he consideration of numerous risks and 🌟fees. Bear in mind that as the cost of insurance decreases—that is, as interest rates increase—equity markets tend to suffer. Conversely, when the cost of insurance is higher, interest rates are lower, and equity markets tend to do better.

Traditionally, to obtain higher returns, the customary practice is to increase the risk exposure of a 澳洲幸运5开奖号码历史查询:portfolio by increasing the proportion of equities held in the portfolio at the expense of cash or fixed-income holdings. Using a🙈 note to seek higher returns comes with the additional cost implied in the principal guarantee. Before purchasing a note, determine whether the potential return is commensurate with the risks and the additional costs.

Finally, conside🍨r the note investment from a portfolio perspective, which means considering its expected return relative to the risk it adds to a portfolio. If suitable, the note will have a higher expected return per unit of risk than the existing portfolio currently offers.