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.
- 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
Follow the series: