What Does Principal-Protected Note Mean?
A principal protected note (PPN) is a fixed-income security that guarantees a minimum return equal to the investor's initial investment (the principal amount), regardless of the performance of the underlying assets.
These investments are tailored for risk-averse investors wishing to protect their investments while participating in gains from favorable market movements.
Principal protected notes are also known as guaranteed linked notes.
Understanding Principal-Protected Note (PPN)
A principal protected note (PPN) is a structured finance product that guarantees a rate of return of at least the principal amount invested, as long as the note is held to maturity. A PPN is structured as a zero-coupon bond – a bond that makes no interest payment until it matures – and an option with a payoff that is linked to an underlying asset, index, or benchmark. Based on the performance of the linked asset, index or benchmark, the payoff will vary. For example, if the payoff is linked to an equity index, such as Russell 2000, and the index rises 30%, the investor will receive the full 30% gain. In effect, the principal protected securities promise to return an investor’s principal, at the time of maturity, with the added gain from the index’s performance if that index trades within a certain range.
A downside to principal protected notes is that the guarantee of principal is subject to the creditworthiness of the issuer or guarantor. Therefore, the prospect of a guaranteed return is not entirely accurate in the event that if the issuer goes bankrupt and defaults on all or most of its payments, including the repayment of investors’ principal investment, the investor would lose his or her principal. Since these products are essentially unsecured debt, investors fall below the tier of secured creditors.
Furthermore, investors must hold these notes until maturity in order to receive the full payout. Since these notes can have long-term maturities, PPN investments may be costly for investors who have to tie up their funds for long periods of time in addition to paying any imputed interest accrued on the notes every year. Early withdrawals may be subject to withdrawal charges and partial withdrawals may reduce the amount available upon a full surrender.
The dark side of principal protected notes was put to light after the collapse of Lehman Brothers and the inception of the 2008 credit crisis. Lehman brothers had issued many of these notes and brokers were pushing it in the portfolios of their clients who had little to no knowledge of these products. The returns on PPNs were more complicated than was presented on the surface to clients. For example, for an investor in one of these notes to earn the return of the index that was linked to the payoff of the note, as well as get the principal back, the small print may state that the index cannot fall 25% or more from its level at the date of issuance. Neither can it rise more than 27% above that level. If the index exceeds those levels during the holding period, the investors receive only their principal back.
An investor that does not want to deal with the complications of individual PPN securities may opt for principal protected funds. Principal protected funds are money managed funds that consist mostly of principal protected notes structured to protect an investor’s principal. The returns on these funds are taxed as ordinary income rather than capital gains or tax-advantaged dividends. Furthermore, fees that are charged by the fund are used to fund the derivative positions used to guarantee the principal returns and minimize risk.