What Is Principal-Protected Investments: Its Risks, Fees, and Regulations

What Is Principal-Protected Investments: Its Risks, Fees, and Regulations

What is Principal-Protected Notes (PPNs)? 

Fixed-income securities known as principle-protected notes (PPNs) promise to restore all invested principal, at least in part. Their unique selling point is this assurance of the initial investment’s return.

Some refer to PPNs, or “notes,” by different names. These are referred to as non-conventional investments, structured securities, or structured products in the US market. They are also referred to as market-linked notes and equity-linked notes in Canada; they are a particular kind of guaranteed investment certificate (GIC). In addition, structured notes and investment instruments exist that resemble PPNs but do not have a principal guarantee.

When the market is favorable, Principal protected notes have the potential to yield excellent profits. An outline of the risk and requirements for conducting due diligence while buying a note is given in this article. The example computations are for an eight-year note with a 4% sales commission, a 2% annual inflation rate, a 5% annual interest rate, and an annual inflation rate. Compounding takes place once a year.

NOTE

  • One kind of fixed-income security that ensures you will at least get your initial investment back is principal-protected notes (PPNs).
  • PPNs are known as market-linked GICs or equity-linked notes in Canada, and structured securities, structured products, or non-conventional investments in the United States.
  • Compared to stocks and bonds, notes are more complicated financial investments, so it’s critical to understand the costs and dangers involved in buying them.
  • Fees for the insurance policy, commissions, management, performance, structuring, running, trailer, and early redemption are all included in the costs.
  • Risks include the chance of zero return, the danger of greater or variable costs, the risk of appropriateness and liquidity issues, and changes in interest rates that could alter the value.

Regulation and Disclosure

Notes are more sophisticated assets with embedded options than stocks and bonds, and their performance is dependent on the connected investment. These characteristics can affect the value of a note and make it harder to estimate its performance.

Regulators are worried that individual investors—especially the less experienced ones—might not understand the dangers involved in buying a note as a result. The necessity for due diligence has also been underlined by regulators like the Canadian Securities Administrators and the National Association of Securities Dealers (NASD). This applies to both the buyer and the seller of a note.

While principal protected notes are not the only structured investment products or structured notes available, other products lack the PPNs’ defining feature of guaranteeing the return of the initial investment.

Numerous Fees

A note is a managed investment product, and it has costs just like any other managed product. Since the primary guarantee with a note is really the purchase of insurance, it makes sense that the expenses involved will be higher than with a stock, bond, or mutual fund. Essentially, the interest lost on buying a note instead of interest-bearing security is the insurance premium.

Several more explicit or implicit expenses are involved, in addition to the insurance payment. They consist of operating, trailer, selling commissions, structuring, management, performance, and early redemption costs.

It is not necessary to focus on every fee; nonetheless, it is crucial to understand the total amount spent on fees as this will reduce your potential return. Paradoxically, it isn’t always easy to find out the whole cost. Trading fees, for instance, are contingent on the volatility of the commodity when using a commodity-linked note, which is based on the constant proportion portfolio insurance (CPPI) method. This is only one of the extra challenges that come with note investment.

“Because purchasing insurance is essentially the principal guarantee connected with PPNs, PPN fees are comparable to insurance premiums and, as a result, more than any fees for investing in securities that do not give a guarantee”.

Many Risks

Every investment has some level of risk. Note-related risks include interest rate risk, the possibility of a zero return, fee risk, appropriateness risk, and liquidity risk, among others.

Interest Rate Risk

Interest rate fluctuations can cause a note’s net asset value (NAV) to swing significantly. The interest rate that applies at the time the note is issued, or the zero-coupon bond, determines the insurance cost for a note with that structure.

The cost of the zero-coupon bond for a note with an eight-year term and a 5% annual interest rate would be $67.68 for every $100 of face value. This would leave $28.32 for options after a 4% commission ($100 – $4 – $67.68). The zero-coupon bond would have cost $78.94 for every $100 of face value if the interest rate had been 3%. 

This would have left $17.06 after commission ($100 – $4 – $78.94) to be used to buy options. Interest rate fluctuations may have an impact on the note’s net asset value (NAV) following the acquisition of the zero-coupon bond, as the zero-coupon bond’s value fluctuates.

The impact of fluctuating interest rates on a note is more complicated and independent of the interest rate in force at the time of issuance, according to the CPPI structure. The insurance cost is contingent upon the timing, magnitude, and impact of rate changes on the associated underlying asset.

“For instance, the cost of a zero-coupon bond will rise and the cushion will be lessened if interest rates fall sharply early in the period. The buffer will be further reduced if the underlying asset’s value declines as a result of the interest rate hike”.

Zero-Return Risk

Real returns and buying power are at stake in the event of a zero return. The difference between the interest rate and the average inflation rate that applies during the note’s duration determines how much of each. Assuming annual compounding, an investment of $100 must increase to $117.17 by the end of eight years in order to keep purchasing power while inflation is 2% annually. 

In eight years, a $100 investment with a 5% interest rate would increase to $147.75. The investor in this instance receives a nominal return of $47.75. But in reality, you’re only getting $30.58 ($147.75 – $117.17 = $30.58).

But in order to keep purchasing power, a return of $126.68 is needed if the eight-year inflation rate averages 3%. With a nominal return of 5%, the true return is only $21.07. The calculations demonstrate that when the inflation rate exceeds expectations, the real return decreases and the purchasing power loss increases.

Risk of Fee

The danger that fees will be more than anticipated and lower the return is known as fee risk. The notes that use a CPPI strategy and are dynamically hedged are particularly susceptible to the risk. If the connected asset’s volatility rises over time, cumulative trading expenses will also increase. However, there is less chance that the note’s performance will precisely mirror that of the connected, underlying asset. One of the note’s additional complications is this.

Risks of Suitability and Liquidity

Suitability risk is the possibility that the investor or advisor does not have enough knowledge of the structured product to decide if it is appropriate for the investor. The risk of having to sell the note before it matures, probably at a discount to its net asset value (NAV), because there may be little or no secondary market, is known as liquidity risk. There is no primary guarantee in the event of an early liquidation.

Additional Risks

Because notes only pay out once, at maturity, they are typically not a good choice for income-oriented investors. Additionally, there is a chance that one will lose purchasing power and not get paid at all.

The creditworthiness of the PPN issuer is a significant risk. You might not get your principle back if that business fails, which means you might lose all you own if the note’s issuer files for bankruptcy.

Possible Situations for Investment

If an investor firmly believes that the asset associated with a note offers the potential to yield a return greater than that of a fixed-income investment, they might think about buying a note. Buying a note gives exposure to this potential without the danger of losing the investment principal, assuming the investor is satisfied with the possibility of no return.

To get around regulatory restrictions that restrict direct investing in alternative investments to accredited investors, an unaccredited investor can buy a note with a return tied to the return of an alternative investment, like a hedge fund. This is made possible by the fact that notes are treated by regulatory bodies like deposits or debt investments.

A savvy investor may use a note to increase exposure instead of immediately establishing a speculative investment. Serving as a floor, the note safeguards the principal invested, ensures a minimum return, and prevents losses.

Conclusion 

Notes are intricate investments that come with a lot of expenses and dangers to take into account. Remember that equity markets typically suffer when insurance costs decline, or when interest rates rise. On the other hand, equity markets typically perform better and interest rates are lower when insurance costs are greater.

Historically, the conventional approach to achieving greater returns has been to raise a portfolio’s risk exposure by raising the percentage of equities held at the expense of cash or fixed-income investments. 

There is an additional cost associated with using a note to pursue higher yields, which is implied in the principal promise. Check whether the possible return justifies the risks and additional expenses before buying a note.

Lastly, evaluate the note investment from the standpoint of a portfolio, that is, weigh its predicted return against the additional risk it introduces. The note, if appropriate, will give a better projected return per unit of risk than the current portfolio does.

Frequently Asked Questions (FAQs)

Are notes with principal protection a wise investment?

Principal Protected Notes (PPNs) are financial instruments that offer the chance to profit from equities market success while guaranteeing a complete return of the principal amount at maturity. PPNs are a good option for cautious investors who want exposure to the equity market but have a low risk tolerance.

What is an investment with a principal guarantee?

A guaranteed investment contract (GIC) is a financial agreement that, for the duration of the agreement, assures principal repayment together with a set or variable interest rate.

What is a structured investment with principal protection?

A structured financial instrument known as a principal protected note (PPN) ensures, if the note is maintained until maturity, a rate of return equal to at least the principal amount invested.