Principal-Protected Note - PPN

What Does Principal-Protected Note Mean?

A principal protected note (PPN) is a fixed-income security that guarantees a base return equivalent to the investor's initial investment (the principal amount), no matter what the performance of the underlying assets.

These investments are tailored for risk-opposed investors wishing to safeguard their investments while participating in gains from good market developments.

Principal protected notes are otherwise called guaranteed linked notes.

Understanding Principal-Protected Note (PPN)

A principal protected note (PPN) is a structured finance product that guarantees a rate of return of basically the principal amount invested, as long as the note is held to maturity. A PPN is structured as a zero-coupon bond - a bond that makes no interest payment until it develops - and an option with a payoff that is linked to an underlying asset, index, or benchmark. In view of the performance of the linked asset, index or benchmark, the payoff will fluctuate. For instance, in the event that the payoff is linked to an equity index, for example, Russell 2000, and the index rises 30%, the investor will receive the full 30% gain. In effect, the principal protected securities vow to return an investor's principal, at the hour of maturity, with the additional gain from the index's performance assuming that that index trades inside a certain reach.

A downside to principal protected notes is that the guarantee of principal is subject to the creditworthiness of the issuer or guarantor. Hence, the prospect of a guaranteed return isn't completely accurate if in the event that the issuer fails and defaults on all or the majority of its payments, including the repayment of investors' principal investment, the investor would lose their principal. Since these products are basically unsecured debt, investors fall below the tier of secured creditors.

Moreover, investors must hold these notes until maturity to receive the full payout. Since these notes can have long-term maturities, PPN investments might be exorbitant for investors who need to tie up their funds for long periods of time as well as paying any imputed interest accrued on the notes consistently. Early withdrawals might be subject to withdrawal charges and partial withdrawals might reduce the amount accessible upon a full surrender.

Impediments

The dark side of principal protected notes was put to light after the collapse of Lehman Brothers and the commencement of the 2008 credit crisis. Lehman brothers had issued a significant number of these notes and brokers were pushing it in the arrangement of their clients who had practically no information on these products. The returns on PPNs were more confounded than was introduced on the surface to clients. For instance, for an investor in one of these notes to earn the return of the index that was linked to the payoff of the note, as well as get the principal back, the small print might state that the index can't fall 25% or more from its level at the date of issuance. Neither might it at any point rise over 27% over that level. On the off chance that the index surpasses those levels during the holding period, the investors receive just their principal back.

An investor that would rather not deal with the inconveniences of individual PPN securities might opt for principal protected funds. Principal protected funds are money managed funds that comprise generally of principal protected notes structured to safeguard an investor's principal. The returns on these funds are taxed as ordinary income as opposed to capital gains or tax-advantaged dividends. Moreover, fees that are charged by the fund are utilized to fund the derivative positions used to guarantee the principal returns and limit risk.