Why Would You Buy A Principal Protected Note?

Principal Protected Notes (PPN’s) have grown in popularity over the last decade. Firms all over Wall Street are consistently selling new issue PPN’s to retail investors. PPN’s come in all shapes in sizes, with investors participating in the so-called upside of baskets of stocks, currencies, commodities, bonds, or stock indices. Investment professionals sell these PPN’s as investments with no downside risk with the potential for gains on the upside.

Asking an investment professional to explain how the potential upside is determined may be easier said than done. PPN performance calculations are extremely complicated and as a result, investment professionals often focus on the lack of downside risk as a key selling point. Representations such as you “can’t lose”, “no brainer” or it is a “win, win” are often cited by disappointed investors.

The risks of a PPN are more severe than the “no brainer” label that these types of investments often receive. PPN’s are subject to the credit risk of the issuer. If the issuer goes under, you may lose the entire investment. PPN’s are also extremely illiquid. In the event you need to sell the investment prior to maturity, there will likely be a very limited number of investors bidding. Furthermore, the bid spread will be fairly wide. In addition, you may not earn any return, which will leave you struggling to keep up with inflation. And if the market accelerates significantly, your return is limited.

PPN’s were concocted by Wall Street to play on investors’ fear during times of uncertain markets. Upside potential with no downside is an easy for sell for the most novice investment professionals. This type of “protection” appeals to many types of investors. However, even when the markets are up, PPN returns are largely underwhelming. The brokers get a nice 3% commission up front and then try and sell you another PPN again when this PPN matures in 2 to 5 years.

It is hard to understand why anyone would buy a PPN. At least if you buy a short-term investment grade bond or CD you will get something in return for tying your money up for a period of years. Unfortunately a PPN’s limited return in good times just isn’t worth it in the event that the issuer goes bankrupt or if you need to sell prior to maturity. Not surprising, the only one getting a guaranteed return is your investment professional.