About Principal Protected Notes
Structured products - of which PPNs are a subset - are synthetic investments, that is, investments which combine derivatives and other financial instruments with the objective of achieving superior risk/return profiles, or cost savings for investors. They are referred to as synthetic since they rely on financial engineering, typically combining traditional securities such as bonds, shares and indices with derivatives such as options, forwards and swaps.
Structured products are designed to help investors reduce risk within their portfolio or to enhance exposure to underlying investments thus maximizing market trends. They can help investors refine their portfolios to more precisely meet their unique risk tolerance levels or return expectations.
The benefits of structured products can include:
- principal protection
- enhanced returns
- reduced risk
- tax efficiency
Types of Principal Protected Notes
Although the individual characteristics of Principal Protected Notes (PPNs) can vary widely, depending on the underlying investments and the terms of each note, in general they come in two basic forms: Zero Plus Option(s) Structure and CPPI (Constant Proportion Portfolio Insurance).
Notes utilizing either of these structures can provide the same basic benefits - principal protection plus exposure to an underlying investment basket that has the potential for high returns. However, depending on which structure is used, there can be wide differences in the level of participation in the underlying investments, potential interest payments, costs, ability to use leverage and the level of risk.
The offering documentation - a master information statement - will tell you which structure is employed. The following pages describe the two basic structures and the relative merits of each approach.
Plain Vanilla - Zero Plus Option(s) Structure
The Zero Coupon Bond structure has the advantage of straightforward Notes using this structure to invest a sufficient amount of their assets in a zero coupon bond to ensure the Note's ability to return 100% of principal at maturity. The remaining assets (the difference between the price of the zero and the sale proceeds) are used to purchase exotic options that provide exposure to the underlying investment category.
The purchase of the zero will typically require the majority of a Note's assets. For purposes of illustration, let's say $70 for every $100 invested in the Note - but in reality this will vary depending on the term of the Note and the current interest rates. The bond, being a zero-coupon bond, makes no coupon payments over its life. Instead, it is issued at a discount from its par value, which is normally expressed as $100. As you can see by the grey line in the chart below, over the course of the Note, the bond will increase in value from its purchase price (in this case, $70) to its par value ($100), thus ensuring that the Note can fully repay principal, if so required. In the illustration, this is depicted by the grey line intersecting with the orange line at maturity.
Simultaneously, the remaining $30 of the Note's original principal (assuming no commission payments or start up fees for the Note) is used to purchase options on the underlying investment. For instance, if the performance of the Note is linked to the S&P 500 Index, it would buy one or more options on the Index. Since options provide leveraged exposure, it may be possible to mirror the performance of a $100 investment in the index with an actual investment of only $30. In the illustration, the performance of the underlying investments, which the Note is linked to via options, is indicated by the blue line.
In this example, since performance of the underlying investment results in a return above the original invested principal, the principal guarantee is never called upon. Instead, the capital that was invested in bonds is used to settle the option contract(s). However, had the performance of the underlying investments been negative and the options expire worthless, the Note would have been able to repay the principal via the zero coupon bond.
In summary, through options, the performance of the Note is linked to the underlying investment - in this case the S&P 500 - while guaranteeing the repayment of 100% of invested principal through the purchase of a zero coupon bond.
Zero Coupon Bond Plus Option Structure
CPPI - Constant Proportion Portfolio Insurance
Constant Proportion Portfolio Insurance (CPPI) - also known as Dynamic Asset Allocation - offers several advantages over the Zero Coupon Bond Structure. First, CPPI Notes can fully allocate their assets to the underlying investments - meaning they have a much better chance of successfully mirroring, and in some cases exceeding, the performance of the underlying investments. In contrast, a Note using the Zero Coupon structure only has those assets left after the Guarantee Bond has been purchased to put toward the underlying investments.
Since CPPI Notes do not actually buy the guarantee bond at the outset, but simply monitor the value of the bond, they are able to commit 100% of their assets to the underlying from the outset, while still ensuring that there are sufficient resources to purchase the bond should conditions warrant. Consequently, Notes using CPPI have more assets to commit to the underlying investments and, as a result, may have a better chance of matching or exceeding the performance of the underlying. Furthermore, Notes using CPPI as their structuring mechanism often have the capability to use leverage to create the potential for enhanced performance.
Constant Proportion Portfolio Insurance
Key Elements of CPPI
Essentially, CPPI is composed of two elements: a) the underlying investments to which the variable interest payment(s) of the Note are linked, and b) the guarantee (a notional investment in a Guarantee Bond that would be needed to return the value of the Note to par - that is, its guaranteed maturity value). For those Notes that can employ leverage, there is what can be thought of as a third element in the form of additional exposure to the underlying investments.
The process is as follows: assets invested in a Note are initially targeted to be 100% invested in the underlying investments. Then, depending largely on the performance of those investments, assets are moved or allocated between the various components on a daily basis.
For those Notes that can employ leverage, if the Underlying Investments are performing well relative to the cost of borrowing, the Notes can automatically borrow additional money to invest on the behalf of note holders, thereby providing leveraged exposure (sometimes up to 200%) to the underlying investments - and the potential for significantly enhanced returns. Sometimes, there is a dollar maximum on the Notes ability to borrow that may cap the leveraged exposure.
The Guarantee Bond comes into play if the underlying investments' return is significantly negative. In this scenario, the Notes automatically de-leverage, reducing exposure - and potential losses - in declining markets. If the downward trend persists, eventually the Note would de-lever completely into the "Guarantee Bond" in order to ensure the ability to completely repay principal.