Principal protection can also be referred to as capital guarantee, absolute return, or minimum return. These terms mean your investment is protected from market-related losses. These notes will usually pay a market-linked return.
Alternate name: Structured note with principal protection
When an investment has a market-linked return, this means that it has a return linked to the performance of additional assets. These investments tend to come with fixed terms. PPNs offer a full or partial return of principal at the date of their maturity. But despite popular belief PPNs aren’t entirely risk-free even though they are designed for risk-averse investors. While the return on investment is guaranteed, this doesn’t always protect you. You won’t see a payout if the issuer of the PPN goes bankrupt.
How a Principal-Protected Note (PPN) Works
A PPN is a type of structured investment product that guarantees a return (full or partial) on the investment once it matures. When you invest in a structured product like this, it often means you don’t own the portfolio of assets. Instead, you are promised payment by the investment product issuers. To better understand how a PPN works, it can be helpful to have more context around how structured notes work in general. Structured notes don’t pay any interest until the bond matures. Structured notes with principal protection are a combination of two things:
A zero-coupon bond (the product that won’t pay interest before maturity) An option or derivative product that has a payoff linked to an index, benchmark, or some sort of underlying asset
There are four main components of structured notes, outlined below.
Maturity
Maturity refers to how long you hold a structured note. This time period may range from as little as six months to as long as 20 years. It is most common for a structured note to mature after two to five years.
Underlying Asset
The underlying asset is the benchmark that the PPN tracks while it is maturing. This is often a stock, commodity, foreign currency, index, or a group of stocks.
Protection Amount and Type
The protection amount is how much you are protected against if the price of the underlying asset goes down. If it doesn’t drop lower than the protection amount, then you’ll get your principal back without being exposed to any losses. There are two types of protection: hard protection and soft protection. Hard protections serve as a buffer against losses. If the price goes down, you’ll only experience losses below the protection amount. Soft protection acts as a barrier against losses. But if the losses go below that barrier, you’ll experience the full loss, not just the difference between the final price and barrier price.
Return or Payoff
This is the amount of money you’ll receive by the end of the term if the necessary market conditions are met.
Pros and Cons of a Principal Protected Note (PPN)
Pros Explained
Somewhat guaranteed: A PPN offers a full or partial return of principal at the date of its maturity, as long as the issuer of the PPN doesn’t go bankrupt.Growth opportunity: You as an investor can gain a level of upside participation through the PPN’s underlying asset.
Cons Explained
Complex terms: PPNs can come with more complex terms than traditional bonds. This can make evaluating the investment opportunity difficult.No FDIC insurance: PPNs aren’t FDIC insured.
