Principal Protected Notes—Not a Free Lunch

by Levi Folk

It is likely no coincidence that the rise of principal protected notes in the market place has followed the tremendous market crash that investors endured at the start of the century. The desire for principal protection is a rational response to prior capital losses even if it comes at the cost of future returns. But investors should understand that a return of capital over any timeframe is an effective loss in real terms.

The most popular strategy for principal protection is based on the value of a zero coupon bond that matures in X years, with X being the number of years to maturity of the note. For example, a zero coupon bond that matures in 8 years and pays $1000 face value costs roughly $750 today, yielding 3.6 percent annually. This value for the bond sets the cost of the guarantee over the life of the note.

The note issuer effectively monitors the value of the bond over the life of the note and ensures that there is sufficient capital available at all times to be able to purchase the bond to provide the guarantee at maturity.

It is patently obvious that the rate of interest on the bond figures prominently into the cost of the guarantee for the note. And a corollary of this relationship is that the lower is the yield on the bond, the longer is the time to maturity for the note. This is evidenced by the extended time to maturity of the more recent note offerings due to the ultra low yield on longer dated bonds recently. Most recent offerings of principal protected notes mature in eight or nine years as a result.

As yields fall, investors are exiting the bond market in search of higher returns, and they are turning to these structured notes in an attempt to recreate that experience. Many of these notes are marketed as an alternative to bonds offering better growth opportunities with less risk than a plain equity investment because of the principal protection.

But the attempt to fill the void left by the collapse in yield in the bond market by issuers of principal protected notes has only been partly successful because these notes ultimately rely on the bond market for achieving the protection. And just as it becomes less rewarding to investors who invest in the bond market for yield, it becomes more difficult for the issuers of these notes to “purchase” this principal protection in the bond market.

As a result of this tradeoff, the value of principal protection is not always fully understood by investors and needs to be put in context. In terms of reported returns, if we don’t include fees, a return of principal is often considered a wash, a zero return on the investment over its life. In reality, a zero return over any number of years is an effective loss in terms of purchasing power due to the rate of inflation and the time value of money.

The value of principal protection is easily determined by standing it on its head. A return of principal in 8 years for example is really only worth what it can be purchased for today which is the cost of the zero coupon bond. In the previous example, $1000 paid in eight years is worth $750 today at a compound yield of 3.7 percent. So a return of principal looking forward translates to an effective loss on the investment.

Consider that an investor could have invested the full amount of principal in the bond market today at the going rate of interest to mature in eight years. Borrowing from the example above, investing in the same zero coupon bond, an investor would have earned $333 in interest on $1000 of principal for a total return of $1333. A return of principal is significantly less than that amount.

The concept of principal protection, while having the feel of neither a loss nor a gain, actually offers less. An investor who receives a return of principal in eight or nine years will find that the purchasing power of that capital is also diminished as well due to inflation.

The principal protection does provide a floor on losses for the underlying investment however, and investors should really assess its value in that context. Asking what is the likelihood of losing more than my principal over eight or nine years is a good question. If that appears to be a high percentage than perhaps a return of principal is not a bad thing.