Monday, September 29, 2008 0 comments ++[ CLICK TO COMMENT ]++

Principal-protected Noteholders Get The Shaft

I have never invested in them but I always assumed they were low risk. I am referring to principal-protected notes. These consist of a diverse set of securities, often producing returns tied to some index. For example, a security that pays you returns based on the performance of the European Dow Jones STOXX Index. Some of these notes promise that the principal will be returned at maturity. I never realized that these were an unsecured claim on the issuer. Bloomberg points out how many investors of notes issued by Lehman Brothers have suffered:

A brochure pitching $1.84 million of notes sold by Lehman Brothers Holdings Inc. in August, a month before the firm filed for bankruptcy, promised ``100 percent principal protection.''

Buyers had ``uncapped appreciation potential'' pegged to gains in the Standard & Poor's 500 Index, the brochure said. In the worst case, they would get back their $1,000-per-note investment in three years. Only the last in a list of 15 risk factors mentioned the biggest danger: ``An investment in the notes will be subject to the credit risk of Lehman Brothers.''

Lehman's Sept. 15 bankruptcy leaves holders of the notes waiting in line with other unsecured creditors for what's left of their money. The collapse has rattled Wall Street's $114 billion structured-notes business, which Lehman, Merrill Lynch & Co., Morgan Stanley and Goldman Sachs Group Inc., all based in New York, used to raise cheaper funding as the credit crisis drove bond yields higher.

Issues like this are what causes retail investor confidence to plummet. It's really a bad situation for the investors in these notes, many of whom were retail investors.

Exchange-traded notes (ETN) are also another instrument where the credit quality of the issuer matters. In contrast, an exchange traded fund (ETF) does not depend on the issuer. ETNs generally track specialized indices or non-equity indexes. An example of an ETN is the iPath Dow Jones-AIG Agriculture Total Return Sub-Index (ticker: JJA).

So anyone investing in these products should be considerate of the credit risk inherent in them.

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