Bad Investments: Principal Protection Notes

(MoneyWatch)  This is the final post in our series on structured investment notes. Today's topic is principal protection notes, which are probably the most common structured products offered. The following is an example from my book, The Only Guide to Alternative Investments You'll Ever Need.

Principal protection notes come in many slight variations, so we'll analyze a hypothetical note offered by Mondo National Bank at the end of the first quarter of 2006. It's similar to a product offered by a major U.S. bank.

• The notes were debt instruments -- unsecured obligations of the bank linked to changes in the Dow Jones Euro Stoxx 50 and the Nikkei 225 indexes, both indexes of large-cap stocks.
• The payment was guaranteed to be no less than the return of the original principal, and the return was linked to the changes in the two indexes.
• The return was based on the lesser of the change in either index, subject to a maximum return of principal, plus 11.7 percent.
• The term was one year with a maturity of March 2007.

Clearly, the attraction was the guaranteed return of principal. The problem was that you would give up too much upside to obtain the downside protection:

The return was based on changes in the indexes, not the total return of an investment in the index. (Thus, you wouldn't earn the dividends.)

You would lose the upside potential beyond the cap of 11.7 percent.

There was no secondary market for the investment, and, therefore, no liquidity.

The note is subject to the credit risk of the issuer, which meant disaster for those invested in notes from Lehman Brothers.

To demonstrate this point, consider an alternative portfolio that was 50 percent MSCI EAFE ex-Japan (a large-cap index) and 50 percent Japanese large-cap stocks (similar to the Nikkei 225). The data covers the period from 1970 through 2006, when the notes were offered.

• With annual rebalancing, this portfolio would have provided an annualized return of 12.3 percent-greater than the maximum return you could earn on the note.
• The gains would have been taxed at advantageous capital gains rates.
• There were 11 years (30 percent of the time) when the principal protection would have come in handy. However, the loss was less than 1 percent in two of those years. If we eliminate those years (assuming you're concerned about such a small loss), the "insurance" was only needed in nine years, or 24 percent of the time.
• The average loss during the 11 negative years was about 13 percent, and the worst loss was just over 24 percent. However, there were 26 years when the portfolio return exceeded the cap and 12 years when the portfolio would have gained more than the worst single loss:
  
  • Nine years with gains over 30 percent
  • Four years with gains over 40 percent
  • Three years with gains over 50 percent
  • Two years with gains over 60 percent
  • One year with a gain in excess of 70 percent

Hopefully, it's clear that you give up much more upside potential than gained in downside protection, which is why a bank wants you to purchase such notes. This happens because stock returns are not normally distributed. They exhibit fat tails, or both large gains and losses. However, the large gains not only occur more frequently than the large losses, they tend to be greater in size as well.

Follow the series:

• Part one: Reverse Convertibles
• Part two: Accumulators
• Part three: Super Track Notes
• Part four: Principal Protection Notes