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Alternative and Complex Investments

Understanding Structured Notes With Principal Protection

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Structured notes—and structured products generally—are retail products designed or “structured” to meet specific investment objectives, such as growth, income or risk management. They do so by combining a traditional security, like a bond, with a derivative component. Importantly, a structured note doesn’t hold an actual underlying portfolio of investments like a mutual fund or exchange-trade fund (ETF) does. Instead, the issuer of the note promises to pay a return based on a formula that incorporates the performance of one or more reference assets.

As the name suggests, structured notes with principal protection are a type of structured product that combines a bond with a derivative component that offers a full or partial return of principal at maturity, regardless of how the underlying assets perform. These products might have safe-sounding names that include some variant of “principal protection,” “capital guarantee,” “minimum return,” “absolute return” or similar terms, but they’re not risk-free. While structured notes have the potential for higher returns than their reference assets, they also have unique risks, and their terms and features can be significantly different and more complex.

How Do These Notes Protect My Investment?

Most structured notes don’t offer any principal protection, meaning that an investor could lose the entire amount invested as a result of the performance of the reference asset or assets to which the notes provide exposure. However, some notes, often referred to as principal protected notes, or PPNs, are designed to provide 100 percent, or full, principal protection if held to maturity. With PPNs, the return of principal is guaranteed by the issuer, in addition to any gains resulting from the formula based on the performance of one or more reference assets. Other structured notes offer only partial principal protection, such as 10 percent.

In the context of PPNs, you may come across terms such as barriers, buffers, and conditional or contingent protection. Barriers and buffers generally reflect some predetermined threshold level that acts as a trigger. A barrier is often associated with contingent protection, or “soft protection,” such that if the specified barrier level is breached then principal becomes fully at risk—i.e., principal protection is conditional or contingent on one or more events occurring. For example, if a note has a barrier of 10 percent and the reference asset declines 5 percent, the investor receives full principal back; however, if the reference declines 50 percent, the investor loses 50 percent.

On the other hand, a buffer typically provides “hard protection” such that if the buffer level is breached, an investor’s potential principal loss is restricted to the extent of losses in excess of the buffer. For example, if a note has a buffer of 10 percent and the reference asset declines 5 percent, the investor receives full principal back; however, if the reference declines 50 percent, the investor loses 40 percent. As a tradeoff, relative to the note with a barrier in the previous example, the potential upside gain of the note with a buffer might be less since it provides the investor with a greater degree of principal protection.

Also, be aware that PPNs might carry call risk, the possibility that the issuer could call or redeem your note before maturity, which can result in gains or losses. Some structured notes with principal protection have automatic call features such that the note will be called and its maturity date accelerated if a prespecified condition is met. Depending on the note’s features, this could result in a full return of principal plus any gains associated with reference asset performance, or it could result in a loss.

Always read the investment prospectus to be sure you know whether a specific note offers full or less than full protection or has protection that is conditional or contingent on other factors.

Importantly, any guarantee that your principal will be protected is only as good as the financial strength of the company making that promise. You could lose all of your investment if the issuer of your note is unable to pay its obligations or goes bankrupt. In other words, any principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. In the event the issuer goes bankrupt, investors who hold these notes are typically considered unsecured creditors and might recover little, if any, of their original investment.

Performance and Cost Considerations

Structured notes with principal protection have the potential to outperform the total return that would be paid on a typical fixed interest rate bond given their market-linked exposure to one or more reference assets. However, these notes also might underperform, possibly significantly, a typical fixed interest rate bond. They could earn no return for the entire term of the note, even if you hold the note to maturity, or you could lose some or all of your investment depending on the note’s features. Also, these notes might not provide full upside exposure to their reference asset(s), meaning that you might potentially forgo significant gains as a tradeoff for principal protection.

On the other hand, some notes might offer enhanced returns, which can result in outperformance relative to the reference asset or assets.

In general, the terms and structures of these notes can be more complex than traditional bonds, making them more difficult for investors to evaluate. And, as with structured products generally, structured notes with principal protection typically have costs that can be relatively high and sometimes difficult to determine or understand.

How Do These Notes Calculate the Return on My Investment?

One of the unique features of structured products is that they can provide a more convenient and customized payoff profile than investors might be able to create on their own. These payoff profiles can include things like market exposure with enhanced return or enhanced yield, absolute returns, or downside protection. They also can involve participation rates, caps on upside performance or floors on downside performance. Features such as using the best- or worst-performing reference asset among multiple assets to determine performance also can be employed.

A note’s payoff profile is dictated by a formula that specifies how the performance of one or more reference assets will influence the performance of the note and, ultimately, your return. Overall, the return on your investment will depend on multiple factors, so be sure that you understand the payoff profile of your note so you can make an informed decision on whether to invest or not.

Can I Get My Money When I Need It?

Structured products, including notes with principal protection, are primarily designed to be buy-and-hold investments. While some notes have relatively short maturities, measured in months, others might extend out for 10 years or more. Structured notes with principal protection tend to have longer maturities, which can be influenced by the market environment (for example, the level of interest rates).

In general, structured notes aren’t listed on an exchange, and there's no guarantee of a secondary market for trading them. These characteristics are often associated with a potential lack of liquidity, so you could have your money tied up for the term of the note.

While they’re not obligated to do so, structured note issuers might be willing to buy back or redeem your notes prior to their maturity date at your request and might provide indicative bid quotes on a continuous basis. Additionally, there might be other market participants such as broker-dealers willing to provide secondary market liquidity for some notes. Valuing a structured note can be a complicated exercise, given the customized nature of the products and variety of embedded components including derivatives. Depending on current market conditions and demand, a note might be quoted at a significant discount to its face value. So, if you want or need to sell your note back to the issuer prior to maturity—even if it offers full principal protection—you might suffer a loss relative to your principal investment.

It's worth noting that, prior to the issuance of a note, the issuer typically will provide an initial estimated value of the note on the cover page of the product’s prospectus or related document such as a pricing supplement. This is based on an internal valuation model that prices the embedded components (such as a bond and options) used to structure the note’s payoff. The initial estimated value is generally less than the price of the note, meaning that you’re investing an amount per note that exceeds its estimated value.

Before investing, carefully read the product’s prospectus or associated document like a pricing supplement. It will provide details of the investment, including fees and risks, important features like the note’s payoff profile and how market-linked gains or losses are calculated, whether there are call provisions, whether it offers a “minimum guarantee return,” and participation rates used to determine how much of the gain in the underlying asset, index or benchmark will be credited to the note.

The bottom line is that structured notes with principal protection can have complicated payout structures and features that can make it hard to accurately assess their risk and potential for growth. In addition, depending on how the note is structured, the distinct possibility exists that you could tie up your principal for upwards of a decade with the possibility of no profit on your initial investment. While your principal might be returned at maturity, that might be all you get back after this lengthy holding period—and, in the meantime, inflation could erode your purchasing power.