Principal-protected notes

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Principal-protected notes


Investment Returns without Principal at Risk

A Principal-Protected Note (PPN) may be suitable for those seeking full protection of their original investment and for investors who have long-term financial obligations. PPNs generally offer a return at maturity linked to an underlying asset, such as a broad-based equity index or a qualified basket of securities. Investors typically give up a portion of the equity appreciation in exchange for principal protection. PPNs are designed for 'buy & hold' investors, with maturities typically of three years and longer.

In its most basic form, a principal protected note typically consists of a zero-coupon bond and an option. At maturity, the zero-coupon bond is redeemed at par, while the option offers participation in an underlying reference asset, which is a security or an index. The option pays the performance of the security or index at maturity if it is above the strike price (call option).

Illustrative example:

  • An investor purchases a principal-protected note maturing in five years, linked to the upside of the S&P 500 index.
  • With a 5 yr US Treasury rate at 4.8%, a 5 yr zero-coupon bond is worth 79.1% ($791 buys $1,000 maturity value). This leaves $209 per note for the issuer (typically a financial institution) to purchase an option on the S&P 500 and pay for administrative costs and brokerage fees.
  • Assuming a five-year S&P 500 call option costs 23.6%, with 2% administration and margin costs, the investor would benefit from an 80% participation in the rise of the S&P 500 index [(20.9 - 2)/23.6]. The zero coupon bond assures that 100% of the principal will be returned at maturity.
  • Upside Scenario:

If the S&P 500 goes up by 40% over the five years, the investor would achieve a return of 32% (80% x 40%) in addition to the original investment. Redemption at maturity would equal 132% of principal.

  • Downside Scenario:

If the S&P 500 is down by 25% after five years, the investor would receive 100% of the original investment at maturity.

For product and risk considerations, click here.

US retail offerings

Example of current offerings August 15, 2009

SEC said to review "Principal-Protected Note" sales

The U.S. Securities and Exchange Commission has asked several financial firms how they market “principal-protected” notes after investors said they lost more than $1 billion on the securities when Lehman Brothers Holdings Inc. collapsed, according to people familiar with the matter.

The agency’s Division of Corporation Finance is looking at how companies describe the products’ risks and whether the term “principal protected” misleadingly implies the investment is guaranteed not to decline in value, said one of the people, who declined to be identified because the inquiry isn’t public.

Citigroup Inc., which used the phrase in its May marketing materials, removed it from a brochure filed June 15 with the SEC. “Citi is working with other banks and industry participants regarding the description of these products,” said spokesman Alexander Samuelson, who declined to comment on the inquiry.

Barclays Plc, Morgan Stanley and Bank of America Corp. are among banks that in offering documents filed with the SEC describe some structured notes, which are bonds packaged with derivatives, as “principal protected.” Individual investors in the U.S. bought $34 billion of all types of structured notes last year, according to, a database used by the industry.

Findings made by the SEC’s corporation finance division may be referred to the enforcement division, which investigates fraud. Kenneth Lench, head of the agency’s Structured and New Products enforcement unit, declined to comment on whether the enforcement division is looking into the securities. John Heine, an SEC spokesman, also declined to comment.

‘Marketing Materials’

Firms must include “full and accurate” disclosures of risks when marketing complex products, such as principal- protected notes, to individual investors, Lench said in a June 25 telephone interview.

“You’ve got these long disclosure documents, but oftentimes there are marketing materials and those have to be accurate as well,” Lench said.

Kristin Friel, a spokeswoman for Barclays, Mark Lake, a spokesman for Morgan Stanley, and Selena Morris, a spokeswoman for Bank of America, declined to comment.

Issuers of principal-protected notes combine bonds with derivatives to offer investors bets on stocks and commodities, with a promise to return their initial outlay regardless of performance. That still leaves counterparty risk, or the danger of not being fully repaid because the issuer itself goes out of business, which is generally spelled out in the prospectuses.

‘Properly Sold’

When Lehman Brothers went bankrupt in September 2008, the principal-protected notes that it had guaranteed plummeted in value. A group of investors said in a lawsuit seeking class- action status that the firm sold at least $1.7 billion of the securities. The investors also claimed that UBS AG brokers provided “misleading” information when using the term “100 percent principal protection” to market the notes.

Allison Chin-Leong, a spokeswoman for UBS, said that the Zurich-based bank “properly sold” the Lehman products, “following all regulatory requirements, well-established sales practices and client disclosure guidelines.”

In April, Citigroup offered to compensate more than 2,700 Spanish investors who lost money on Lehman structured notes, without admitting liability. Some buyers of Lehman principal- protected notes have won restitution from their brokers in Financial Industry Regulatory Authority arbitration cases. Finra, the industry-funded brokerage regulator, sent a notice to brokers last year telling them to ensure that marketing materials for the securities are “fair and balanced.”

UK structured products

Source: FSA

Some structured products are deposits rather than investments. Structured deposits (often marketed as ‘guaranteed equity bonds’) can only be offered by firms such as high-street banks which are able to accept deposits.

Your money is treated as if it is in a restricted-access bank account but, unlike a traditional savings account which pays a fixed rate of interest, the interest you receive will depend on the performance of a stock market index or asset.

It is important to note that you may not be covered by the Financial Services Compensation Scheme (FSCS) if the firm holding your deposit goes bankrupt – see Related links.

Key risks and product features

You could lose some or all of the money you put in to these products, so make sure you understand the risks before investing.

The following list is not exhaustive and not all risks or features are applicable to each type of product.

  • Credit risk – a product may be designed and marketed by a ‘plan manager’, but the returns and guarantees are generally provided by a third party. If that third party goes bankrupt, you could lose some or all of your money, even if a product is called ‘protected’ or ‘guaranteed’. You may not be covered by the FSCS if this happens.
  • Market or investment risk – if the return of your original money depends on the performance of a stock market index or asset, then if the level of that index or asset falls during the term of the investment you may lose some or all of your original money. If this happens, you could lose your original money very quickly.
  • Liquidity risk – the benefits offered (such as capital protection) are usually only available if the product is held for the full term. It may be difficult or expensive to access your money before the end of the investment term.
  • No dividend income – even if a product is linked to the performance of a stock market index, you will not receive any dividend income from the companies which make up that index.
  • Capped returns – many products restrict or cap the level of the return you can receive, so if an index or asset price rises above the level of that cap, you do not receive additional returns.
  • Averaging – the return offered by some products can depend on several measurements of index levels or asset prices during the life of the investment. While this can protect you from short-term falls in an index level or asset value, it may also prevent full exposure to any gains.
  • Limited participation – many products only offer a proportion (for example 50%) of any gains made by the index or asset to which they are linked.
  • Inflation – even where a product is marketed as ‘100% capital protected’, the real value of the capital can suffer significant erosion by inflation over the term of the investment.
  • Tax – the tax treatment of structured products depends on their legal structure and on any tax wrapper in which the product is held.

Structured products are often complicated. You should seek professional advice if you are in any doubt about the potential risks and returns involved – see Getting help. Recent developments

The Lehman Brothers' bankruptcy in 2008 raises serious issues for the UK structured products market. So, we and the Financial Ombudsman Service (the Ombudsman) have agreed to consider issues relating to Lehman-backed structured products under the wider-implications process with the aim of achieving the best outcome for all the consumers involved. The wider-implications process addresses cases where the underlying issue affects a large number of consumers or firms. The process allows us to explore whether a regulatory solution may be more appropriate than the Ombudsman deciding individual cases. For more information about the process see

ASIC releases product disclosure statements

ASIC has today released updated Regulatory Guide 168 Disclosure: Product Disclosure Statements (and other disclosure obligations) (RG 168).

ASIC Commissioner, Mr Greg Medcraft, says the updated guide reflects key findings from ASIC’s recent report Review of disclosure for capital protected products and retail structured or derivative products (REP 201) which was based on a program by ASIC which involved the review of 64 Product Disclosure Statements (PDS) for adequacy of disclosure.

‘The updated guide will assist issuers of capital protected products and retail structured or derivative products to make more effective disclosure to prospective investors,’ Mr Medcraft said.

In particular, ASIC recommends issuers:

  • clearly explain counterparty risk, and include supporting financial information, to ensure retail investors can assess the issuer’s financial ability to meet its counterparty obligations

of capital protected products,

  • ensure disclosure is sufficient so that investors can assess the likelihood of early termination or any other significant limitations of these products
  • provide better disclosure of break costs that may apply where an investor seeks to terminate or redeem a product before its maturity date.

The update does not otherwise change ASIC’s existing policy on PDS disclosure.

Updated RG168 consolidates guidance currently provided by ASIC in various locations and formats and provides a single guide for product issuers and other individuals responsible for PDSs and other disclosure obligations. It also refers to recent reforms to the Corporations Act and Regulations relating to shorter, simpler PDSs. These were developed by the Financial Services Working Group (comprising officials from the Department of Treasury, the Department of Finance and Deregulation and ASIC).

Further amendments may be made to RG 168 in due course that provide guidance about these reforms.


RG 168 contains ASIC’s Good Disclosure Principles to help product issuers comply with the disclosure requirements and also promote good disclosure outcomes for consumers. The Good Disclosure Principles are:

  • (a) disclosure should be timely;
  • (b) disclosure should be relevant and complete;
  • (c) disclosure should promote product understanding;
  • (d) disclosure should promote product comparison;
  • (e) disclosure should highlight important information; and
  • (f) disclosure should have regard to consumers’ needs.


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