Principal protected notes (“PPNs”) are notes which promise maturity payoffs of at least the face value of the note. Principal protected notes typically do not pay interest coupons but instead pay more than the face value of the note at maturity if the value of the reference asset increases over the term of the note. If the reference asset has a positive return over the term of the note, at the note’s maturity the note pays investors the face value plus a positive return. If the reference asset has a zero or negative return over the term of the note, the note pays only the face value to the investor.
The simplest principal protected notes have payoffs at maturity which are very similar to the payoffs to a combination of a zero-coupon unsecured subordinated note issued by the brokerage firm and a call option on the reference asset. Basic PPNs are most frequently linked to a stock index or basket of stock indexes.
Absolute Return Barrier Notes (“ARBNs”) are PPNs that return the face value at maturity if the reference asset’s value has ever closed outside of a specified range during the term of the note. If the reference asset’s daily value has never been outside the range, the ARBN pays the face value plus the absolute value of the reference asset’s return. ARBNs are frequently linked to commodities and exchange rates.
Many PPNs are linked to interest rates and pay periodic coupons. STEEPENERS, for instance, pay coupons that depend on the difference between two yields of different maturities. Range Accrual Notes pay coupons that depend on what fraction of the days in a quarter a particular relationship between yields holds.
A few PPNs have maturity payoffs in excess of the face value of the note only if the reference asset has lost value during the term of the note. These are still PPNs though, as their defining feature is that they pay at least the face value of the note at maturity with any additional payments depending on the reference asset’s value.
The “Principal Protected” label is almost always misused in structured product marketing materials. The principal in a “principal protected” structured product is typically “protected” or “guaranteed” to exactly the same degree as the principal in an unsecured subordinated note issued by the brokerage firm is protected or guaranteed. The terms “principal protected” and “guaranteed return of principal,” combined with the superfluous complexity of the coupon payment formulas, were effective at masking the substantial credit risk in structured products, especially during the financial crises of 2008-2009.
Because principal protected notes purport to guarantee principal, they are easy to market to investors seeking low-risk investments. The “100% Principal Protection Notes” name is a misleading name which makes it easy to neglect the credit risk and liquidity risk inherent in the notes.
Principal Protected Notes have been sold under different names by different brokerage firms. Table 1 lists a few of the basic PPNs which have been sold under different brand names by various brokerage firms.
|Brokerage Firm||Brand Name|
|Barclays||Principal Protected Note|
|Barclays||Principal Protected Absolute Return Barrier Note|