Principal Protected Investments

Principal Protected InvestmentsFINRA recently issued an Investor Alert providing guidance and information for investors on the popular investment product called structured notes with principal protection.  The term “structured note with principal protection” refers to any structured product that combines a bond with a derivative component—and that offers a full or partial return of principal at maturity.

Structured notes come by different names and often refer to promises of “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms.  THEY ARE NOT FREE OF RISK.  Here are some the following types of risk:

1.      Credit risk:  any promise to repay some or all of the money you invest will depend on the creditworthiness of the issuer of the note—meaning you could lose all of your money if the issuer of your note goes bankrupt.

2.      Structural risk:  some of these products have conditions to the principal protection or offer only partial protection, so you could lose principal even if the issuer does not go bankrupt. For example, the principal protection does not apply unless some contingency is met—sometimes called “contingent protection”—so it may provide no protection at all.

3.      Call / Maturity risk:  principal protection may be offered only when the investor holds the note to maturity.  Additionally, the issuer may call or redeem the note before maturity, resulting in a return of the principal but a loss of the income payments.

4.      Liquidity risk:  If you need to cash out your note before maturity, you should be aware that this might not be possible if no secondary market to sell your note exists and the issuer refuses to redeem it. Even where a secondary market exists, the note may be quite illiquid and you could receive substantially less than your purchase price.

5.      Return risk:  The return on your investment—over and above any principal guarantee and assuming you hold the note to maturity—will depend on a host of factors, including the method the issuer uses to calculate gains (or losses) linked to the performance of the underlying asset, index or benchmark (the “market-linked” returns), the note’s participation rate and any minimum guaranteed return.

FINRA’s Investor Alert provided the following questionnaire that investors should use when considering whether to purchase a structure note:

  • How do I know whether this product is appropriate for me given my overall investment objectives?
  • What is the level of principal protection offered? There is a big difference between 100 percent return of principal and 10 percent return, or something in between. Know your protection percentage.
  • Are there conditions to the principal protection? For example, is the protection contingent on the occurrence of specified events?
  • What are the fees and other costs? Products offering principal protection can be expensive. You should pay particular attention to the fees of any product you invest in, including those that offer principal protection. Ask your investment professional to explain all of the fees and costs associated with the investment.
  • How long will my money be tied up? Structured notes with principal protection are meant to be held to maturity and are often designed for long-term investors. If you need your money back early, you could pay a significant penalty. Furthermore, any downside protection offered might only kick in after a long lock-up period—or it might require you to hold the note until maturity.
  • Can I sell or liquidate before the maturity date? While it is easy to turn many investments into cash, liquid markets for some structured products might not exist. If you need to sell your structured note with principal protection before it matures, you might have to do it at a price less than the amount you paid for it, or you may not be able to sell it at all. This is true even if the product has a ticker symbol or has been approved for listing on an exchange.
  • Is there a call feature? If so, be sure you understand what can trigger the call and when is the earliest the investment may be called. You will also want to ask your investment professional what might be your game plan in the event your note gets called.
  • Are potential gains limited? Some structured notes with principal protection may have limits or caps on the gains you can earn based on the performance of the underlying asset, index or benchmark.
  • What are the tax implications? You might wish to consult with a tax advisor to understand the consequences of any particular investment, including imputed interest and any foreign tax consequences.
  • How does the pay-out structure work? Is it possible to lose money, or not have any gain at all, even if the underlying asset, index or benchmark goes up? Purchasing a structured note with principal protection does not guarantee positive returns. For example, the underlying asset, index or benchmark might not increase in value—or even if it does, there may be conditions, which in some cases can be counterintuitive, that limit your gains. And, if the entity backing the principal protection at maturity goes bankrupt, you could lose your entire principal.
  • What unique risks will I take on as a result of being exposed to the underlying asset, index or benchmark?
  • What is the credit risk of the note? Remember that any principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. Be sure to find out as much as you can about the financial condition of the issuer and read its disclosures as carefully as you would for any other bond investment.
  • What other risks are associated with this particular product? Be sure you understand how the derivative component of the note impacts the pay-out structure—and ultimately your return.
  • What other investment choices are available to me? Carefully consider what might be a good fit for you, and whether there are alternatives to the product you are considering.

Investing in fixed income oriented investments, like structured notes or principal protected notes, has risks that should be explained to the investor.  Just because an account or an individual investment has decreased in value does not necessarily mean that a financial adviser has acted inappropriately.  At Crary Buchanan, we provide consultations concerning negligence arising from improper financial advice.  We invite you to call us to discuss your rights and remedies under the law.

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