Introduction
Technology has changed the financial landscape for investors as a whole. You have so many investment products that are brought to you across the table.
As a newbie investor, it can be overwhelming to choose between traditional bonds, deposits, or equities. Moreover when underlying options have variations in linked-in assets, mortgages, credit notes, equities, stocks, futures, options, or currencies. It becomes difficult to choose a plan not only safeguards your principal investment but the chosen vehicle also helps you achieve returns or gains from the plan that stands chosen.
It therefore becomes predominantly important for you to know or understand how investment plans work. On this note, this blog outlines how principal-protected structured notes work and why it is gaining popularity among investors.
Unlike traditional investments, Structured notes with principal protection refer to a class of products wherein the investor is promised a complete return of capital sum as and when the notes reach their term of maturity.
For instance, Equity-linked notes with principal protection offer complete value of the investor’s principal money irrespective of how the underlying assets perform in the market.
Here, the note combines a debt component with an underlying asset. The debt component protects the principal amount while the returns of the notes are determined through the performance of the underlying assets the notes are linked to.
However, principal-protected structured products offer a guarantee of capital payouts despite the performance of underlying assets in the equity or derivative marketplace.
As the note links the debt component with equity assets, you may have the assets subject to fluctuations in market conditions. The volatile market scenarios may allow asset values to rise or plummet.
As principal-protected structured notes come to you with a 100% capital guarantee, you are assured of your initial investment amount at the time the notes mature.
Principal Protected Structured Notes- Characteristics Explained
A structured note typically does not hold a direct investment like mutual funds or equities like exchange-traded funds or ETFs.
For a structured note, the bond component provides capital protection to investors. The other component which is asset allocation comprises equities, shares, and a basket of high-paying stocks, or currencies. While the fixed bond component protects capital investment, the returns are linked to the performance of underlying assets the note is linked to.
On a similar note, structured notes with principal protection focus on the return of the complete value of the principal amount or at least a partial return of the capital investment as their underlying objective. This is regardless of the performance of underlying assets.
However, there is an important factor that you must read through between the lines. Although these notes come to you with terms like ‘principal-protection’, capital-guarantee, minimum-returns, and other safe-sounding words, they are not risk-free either.
When structured notes can offer potential gains that surpass the yields you earn over the actual referenced assets, these notes also come to you with liquidity and market risks.
The terms and conditions therefore vary concerning what is stated on the initial offering documents. The creditworthiness of the issuer also plays a key role in principal protection. For instance, if the firm goes bankrupt, then the notes become unsecured and that is the risk of losing your whole capital investment.
That primarily explains why these notes are complex to learn or understand.
How Do These Notes Protect Your Investment Portfolios?
The investment vehicle uses certain formulas to make notes fully principal-protected or partially principal-protected. Let us understand in detail:
- Barrier
As you know, structured notes rely on the performance of referenced assets to highlight the level of income investors can earn through the term of the notes.
Barriers refer to initial prices or percentage losses set on structured notes. The barriers are usually added to mitigate losses in a volatile market scenario.
A specified barrier limit provides soft protection to investors as you do not allow the referenced assets to breach the pre-set barriers. As long as the prices of assets do not breach barrier limits, the investor’s capital remains protected.
On the contrary, if the prices of assets exceed or decline barrier limits, the investor’s capital is exposed to risk. In other words, they can lose a partial or entire amount of their capital.
- Buffers
Buffer limits provide hard protection to the investor’s capital funds. As long as the price declines do not go above set buffers, the investor can get his entire principal back.
On the other hand, when the prices of referenced assets, decline below buffers, then the capital is protected to the buffer percentages as set but loses the remaining portion of his capital sum.
For instance, if the note is buffered by 10%, and the price of the asset declines by 5%, the investor gets his principal back. On the contrary, if the underlying assets decline by 25%, then the investor loses 15% of his capital sum (25% – buffer of 10%).
- Call Risks Of The Credit Issuer
Sometimes, the credit issuer or product issuer may call off notes even before they reach their term or maturity dates. As the call-off dates are auto-triggered, the referenced assets must reach preset barriers or go above initial purchase unit prices.
More often than not, these are auto-callable or short-term investment notes. The investment holders get the principal amount and coupon payments with every auto-call trigger. In case of failed auto calls, the coupons are redeemable during the next active auto call.
These notes are auto-called as and when pre-specified conditions of the notes are met. The investors receive their principal amount and gains of the referenced assets although losses here are inevitable while performing assets decline initial strike prices or purchase points at the beginning of when the notes were designed.
- Contingent Coupons
Mostly, PPNs have contingent income coupons paid out to investors monthly or quarterly. The coupon yields a sufficient return of capital even if the investor receives a lesser sum of capital as the notes reach their term of maturity. The interest rate is again not fixed here.
Investors love to invest in PPNs that give them contingent coupons as they are paid out periodically. However, these income payouts are not fixed and are subject to market terms and conditions.
Performance Vs Cost Considerations
On a general note, principal-protected structured notes might outperform providing investors with their principal and the potential gains of referenced assets, added to their capital investments. While the prices of referenced assets may remain stagnant or fail to perform even when these notes are held to their maturity.
In the eventuality of notes wherein linked-in assets fail to perform at expected levels, the investor may lose a partial or full value of the capital amount. These notes may not provide full upside exposure to their referenced assets. Meaning, that investors may lose significant gains as a trade-off against their principal guarantee aka the return of principal money.
On the other hand, when notes vis-a-vis their referenced or linked-in assets outperform in the market, investors may get far better yields on structured products over what they may receive via traditional bonds or mortgages.
As structured notes combine debt with equity, it becomes a little more complex for investors to gauge/ evaluate how things work.
How Do Principal-Protected Structured Notes Calculate Returns On Investment?
Structured notes provide more customized investment portfolios as against standardized financial instruments. Investors get a wider market exposure over fixed-income securities or bonds.
Therefore, a well-curated profile helps them earn attractive returns over traditional forms of investments like bonds, mortgages, or even equities.
Through well-defined techniques like adding caps on potential losses or setting up barriers against potential gains, your returns on investment for notes get balanced so that investors get maximized returns once the notes mature. Even if assets experience downfalls, you are provided with soft-cover downside protection against capital erosion.
Call or put options get embedded into structured notes to mitigate losses and gains for the investors. Coupons, interest earnings, and dividend disbursements are different sources of income structured notes can offer you as an investor. The index or benchmark of market-linked assets also plays a significant role in determining your rates of return from the notes.
Therefore, investors must look at the performance of linked assets or equity index values. You can oversee how your investment works based on a formula that suits you the best.
However, potential gains over the investment for structured notes are not fixed but linked to the performance of the underlying assets.
Will You Be Able To Take Out Money When You Most Need It?
All types of structured notes work on buy and hold principal as against buying and selling that operates in the equity market. With respect to principal protected notes too, the concept remains the same.
However, when you have tradeable equities linked to your notes, you can trade them in secondary markets. However, when you allow the notes to stay until they mature, you get your earnings plus principal.
Trying to dispose of the notes in a secondary market might involve you getting them done at a distress sale thereby eroding a significant portion of your initial investment.
However, for emergencies, you can trade your notes in a secondary market and take the proceeds whatsoever. This is because your current market conditions or the asset’s downside performance may be difficult to determine.
The Bottom Line
The liquidity for structured notes remains limited as compared to equities or currencies. You may have to deal with market enclosures and read prospectuses thoroughly before investing in structured notes.
Accessing the creditworthiness of the issuer of your note also remains a determining factor before you expect a full return on your amount invested.
Therefore, investors must carefully weigh the pros and cons of notes before trying to invest in them. As you hold these notes until maturity, the payoff significantly increases.
Frequently Asked Questions or FAQs
1. What is the minimum return for a PPN?
Answer: For a principal protected note or a PPN, you at least get a complete value of capital returns when the note is held to maturity. This is despite the performance of the note whose underlying assets get exposure in the marketplace.
2. Can a zero-coupon bond relate to a PPN?
Answer: A zero-coupon bond is purchased at a discounted value and redeemed at the face value. However, zero-coupon bonds do not come under structured notes. However, you get the face value of the bond from the product issuance firm. Therefore, it has a mild correlation to how a PPN works.
3. How does the valuation of principal-protected notes take place?
Answer: The PPNs guarantee the capital return to the investor. In other words, you get your invested principal back and the notes offer upscale returns linked to the performance of underlying assets that the notes are linked to.
4. Are the notes redemption subject to the creditworthiness of the product issuer?
Answer: Yes, the possibility of investors receiving fair-value returns and principal money at the time of redemption is subject to the creditworthiness of the product issuing firm.
If the issuer goes bankrupt, then the notes may not fetch complete capital investment at the time of redemption.
5. How are PPNs designed to provide 100 percent capital protection?
Answer: Well, these are 100 percent capital-protected notes that are offered to investors. Their money is invested through govt bonds, fixed annuities, or other reliable sources of income generators while product issuers design the products.
Although PPNs are also linked to market assets, the market performance does not affect the payment of capital to investors as the notes mature.
