In a low-interest-rate world, high-yield investments offering principal protection are enticing to investors. But the complexity of some high-end investment products has the Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission's (SEC) warning investors to look before they leap.
In an alert titled "Structured Notes with Principal Protection: Note the Terms of Your Investment," the regulators warn investors that these structured products may not be what they seem. Although they are marketed under a variety of names with a "principal protection" component—e.g. "absolute return" and "minimum return"—the true extent of their safety is never obvious at first glance. Investors need to read the fine print to determine whether they are suitable for their investing needs and risk tolerance.
Structured notes with principal protection combine the "guaranteed" return of a zero-coupon bond with a derivative component carrying greater profit potential. The derivative component of the note is linked to an index, benchmark or an underlying asset. If the value of the underlying asset increases over the term of the note, the investor may reap a greater return than they would have with just a bond; but that scenario is by no means assured.
The first confusing feature of these notes is that purchase of a structured note with principal protection doesn't entitle the purchaser to ownership of the assets on which payout of the structured note is based. As a result, the note's principal guarantee depends on the financial security of the issuer. If the issuer goes bankrupt, the investor can lose 100% of his or her investment.
Investors also need to understand that the "guarantee" provided by structured notes with principal protection may not be a 100% guarantee. These structured products can pay back some, or even all, of the investor's principal if the investor holds the product to maturity—and the principal return function works regardless of whether the assets underlying the product decline in value. But buyer beware: The principal protection function of the notes often doesn't protect 100% of the investor's principal and may protect as little as 10%.
Another often misunderstood aspect of structured notes is the method under which returns are calculated. Some notes pay periodic interest payments, others don't. And the market-linked gains component of the notes can vary wildly between products. For example, some compare an index at two distinct dates and others may compare the highest value of the index during the term of the note with its value at the start of the term. Still others (the shark-fin variety) allow full participation in gains up to a certain level and then severely curtail participation if the index rises above that level.
