Saturday, June 04, 2011

Principal protection... not always protected. When purchasing any security, its a good idea to understand the counter-party implications and any bankruptcy priority issues that surface in case of calamity. Typically, these risks are NEVER priced in, resulting in an expensive mechanism that is, for all intents and purposes, pure Beta.

(snippet from an article in my inbox)
Worried about the increasing number of retail investors jumping into complex financial products, securities regulators Thursday warned that structured notes with principal protection are not risk-free.
The Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. warned that such an investment may come with confusing terms that actually guarantee as little as 10% of the investment and limit the amount investors gain on the upside. It also can tie up those funds for a decade.

Structured notes with principal protection combine a zero coupon bond— that is, one that pays no interest until it matures — and an option whose payoff is linked to an underlying asset, index or benchmark (such as currencies, commodities, the Russell 2000) or a basket of benchmarks. The payoff can vary, based on the performance of the linked index, but the bonds offer the prospect of a greater return than money-market instruments, which makes them appealing.

“The current low-interest-rate environment might make the potentially higher yields offered by structured notes with principal protection enticing to investors,” said John Gannon, Finra's senior vice president for investor education.

Investors typically are interested in such products because they believe they are gaining possible market upside while protecting their principal.

What investors believe and what's true are not necessarily the same thing. The SEC says principal-protected notes vary wildly by issuer, and investors tend to ignore — or don't understand — what's spelled out in prospectuses.

The obvious problem with principal-protected notes: Often, the principal isn't protected. Some sellers of the notes do indeed guarantee 100% of principal. That's fine, unless the issuer of

the note goes bankrupt, in which case the investor will likely lose all or most of the principal.

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