A reassuring name does not make an investment risk-free. That is why FINRA and the SEC have issued a new warning about structured notes with principal protection.
The market for these products has grown in recent years, and that’s not really a good thing. Terms like “principal protection”, “absolute return” and “capital guarantee” are meant to give investors a sense of security. But, as the investor alert cautions, these products are absolutely not risk-free.
A structured note with principal protection basically combines a bond with an additional component offering a payout linked to an index, benchmark or underlying asset.
One problem with these products: hidden costs. Depending on the way the product is bundled, costs can be high. And “these costs generally are not transparent to investors”, according to the report.
Another problem: liquidity. These products are typically illiquid, leaving your money tied up for several years. Some structured notes may allow a redemption, but that’s after a “lock-up period”…and after a fee. Others may allow investors to sell before maturity in a secondary market…but at a significant discount to the guaranteed amount.
And yet another problem: participation rates. A structured note with principal protection is supposed to allow investors to benefit when the index or benchmark component increases. But the participation rate limits the amount of the gain that is credited to the note (see example below). Simply put: “a note might be structured in a way that your upside exposure…is limited or capped, which is generally a tradeoff for offering the principal protection”, according to the agency alert. So, in the end, the downside risk could be greater than the upside potential.
The next problem: limited protection. The principal protection offered varies significantly from one note to the next. While some may return 100% of the principal at the maturity date, some guarantee as little as 10% of the principal. And others place contingencies on the principal protection, referred to as “contingent protection”…which could amount to no protection at all.
And one more thing: alternatives. There are other ways to earn a return. According to the alert, structured note investors “could have assembled a similar bundle of investments on (their) own at a lower cost – and with potentially higher returns”.
The bottom line: according to FINRA and the SEC, when it comes to structured notes with principal protection, “note the terms of your investment”. And remember that “any guarantee…is only as good as the financial strength of the company that makes that promise” – just ask investors who purchased structured notes with principal protection from Lehman Brothers.
And while the higher yields and guarantees of structured notes with principal protection are enticing, “chasing a higher yield by investing in these products could mean winding up with an expensive, risky, complex and illiquid investment”.