Principal-protected notes (PPNs) guarantee to return, at a minimum, all invested principal. The potential to obtain attractive returns, given favorable market conditions, also exists. The distinguishing feature of a PPN is its principal guarantee. The names used to describe PPNs, or "notes", vary. In the U.S. market, the names include structured securities, structured products or non-conventional investments. In Canada, names like equity-linked notes and market-linked GICs are common. Be aware that structured products, which are similar to notes but without a principal guarantee, are available.

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%. Compounding is on an annual basis. (For an overview of these tools, see Principal-Protected Notes: Paying For A Guarantee.)

Regulation/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 their valuation.

Because of this, regulators have expressed concerns that retail investors, especially the less sophisticated ones, may not appreciate therisks associated with the purchase of a note. Regulators have also emphasized the need for due diligence, both on the part of the seller, and the purchaser, of a note.

Additional insight into the concerns of regulators is available from The National Association of Securities Dealers (NASD) and Canadian Securities Administrators web sites. As well, valuable insights are available in Investor Watch: Principal-Protected Notes (PPNs).

Numerous Fees
A note is a managed 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 investment because the principal guarantee is really the purchase of insurance. The insurance premium is the interest foregone by purchasing a note rather than an interest-bearing security.

Besides the insurance premium, there are numerous other explicit or implicit fees. These include selling commissions, management fees, performance fees, structuring fees, operating fees, trailer fees and early redemption fees. 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 commodity-linked note, based on a constant proportion portfolio insurance (CPPI) strategy, trading fees depend on the volatility of the commodity. This is one of the added complexities to investing with notes.

Numerous Risks

All investments come with exposure to risk. Investors need to understand the risks associated with an investment to make prudent investment decisions. The risks associated with notes include interest-rate risk, the risk of a zero return, fee risk, suitability risk and liquidity risk. (To learn how risk tolerant you are, see Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)

Interest Rate Risk
Interest rate changes can significantly affect the net asset value (NAV) of a note. For a note based on the zero-coupon bond structure the interest rate in effect at the time of issue determines 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 face value, leaving $28.32 after 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, leaving $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 rate change on the underlying linked asset. For example, if interest rates decline significantly 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 value of the underlying asset to decrease, the cushion will suffer further reduction. (To keep reading on interest rates, see Trying To Predict Interest Rates, Forces Behind Interest Rates and It's In Your Interest.)

Zero-Return Risk
The risk of a zero return is a loss of both 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%, an investment of $100 must grow to $117.17 by the end of eight years. A $100 investment receiving a 5% rate of interest would grow to $147.75 in eight years. In this example, the investor foregoes a total return of $47.75, $30.58 of which is real return ($147.75 – $117.17 = $30.58). However, if the rate of inflation averages 3% over the eight-year term, a return of $126.68 is required to maintain purchasing power and the foregone real return will be $21.07. 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. This 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 note 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 secondary market. With early liquidation, there is no principal guarantee.

Not Suitable for Investors Requiring Income
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 purchasing power. To meet income requirements, appropriate investments include government bonds, high-grade corporate bonds, annuities and dividend-paying, blue-chip stocks.

Potential Note Investment Scenarios
An investor may consider purchasing a note if he or she has 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 the investment principal.

An unaccredited investor may purchase a note with a return linked to the return of an alternative 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 speculative position, may use a note to gain exposure. Acting as a floor, the note provides downside protection, guarantees a minimum return and protects the invested principal.

Closing Considerations
Notes are complex investments that require the 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. (For related reading, see How Interest Rates Affect The Stock Market.)

Traditionally, to obtain higher returns, the customary practice is to increase the risk exposure of a 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. The issue to resolve before purchasing a note is whether the potential return is commensurate with the risks and the additional costs.

Finally, consider the note investment from a portfolio perspective, which means to consider 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.

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