Be Careful With Principal-protected Notes (or Similar Instruments)... Be Cautious With ETNs As Well

I can't even believe I considered these instruments for my mom's account at one time. It's amazing how useless these things can end up becoming. I'm talking about principal-protected notes (PPNs), which is called different things in other countries. These notes typically guarantee principal while delivering returns tied to some index. For example, a 5 year note may guarantee principal while providing 1.5 times the return on the Nikkei stock index if the Nikkei rises between 20% and 30%.

These notes are often constructed using derivatives to synthetically replicate the returns. In the example above, the note might invest 90% of the money in Government of Canada bonds while investing 7% in Nikkei call options and 1% in yen-C$ swap. The issuer takes 1% as profit. The government bonds will mature at 100% of the principal value (if you add the interest to it); the options contracts will produce 1.5x the return in 5 years if the Nikkei rises between the specified levels (the derivatives are purchased to satisfy this condition); and the currency swap would be to protect the currency risk. I'm just making up numbers here but you get the point.

The attractive thing about these things is that they act like bonds on the downside, while behaving like equity on the upside. These products would be attractive to retirees and others who don't want to take capital losses while trying to profit from any upside. At least that was what they seemed like.

These notes are turning into a disaster with the fall of some players. Bloomberg mentions the story of Lehman Brothers principal-protected notes that have turned out to be possibly worthless.

Structured notes, sometimes marketed as ``structured equities'' or ``hybrid financial instruments,'' are constructed by banks and Wall Street firms from a combination of bonds, stocks, commodities, currencies and derivatives. About a third of the $114 billion sold last year in the U.S. promised full or partial principal protection.

The banks, which rely on market borrowings to finance their loans, trades and investments, sold more structured notes to retail clients as the credit crisis made plain-vanilla bonds more expensive to issue in institutional debt markets. Sales of the notes quadrupled in the U.S. during the past four years, according to data compiled by London-based research firm mtn-i.

...

Lehman's Sept. 15 bankruptcy leaves holders of the notes waiting in line with other senior unsecured creditors for what's left of their money. Notes with full principal protection are trading at 10 cents to 14 cents on the dollar, according to New York-based SecondMarket, which provides a marketplace for securities that are illiquid, or barely trade.

Canadians are not immune. The situation is quite dire for anyone owning Lehman Brothers notes but there are issues with Canadian PPNs as well:

Because of the "protection" feature and the use of leverage (in some cases), if the underlying fund or index goes down substantially at the beginning of the note's term, then a "protection event" occurs and the note is monetized. When this happens, the market exposure is reduced or eliminated, and the remaining assets are invested in bonds in order to ensure that investors get their capital back. When the market goes back up after such an event, investors have no skin in the game and therefore no possibility of positive returns.

It was reported this week that a significant number of PPNs have had a protection event. Bank of Montreal is the leader with 69 such notes. Because of the weak markets, these notes no longer have any upside potential, even though some have five or more years to run. Who knew?

At least the principal is protected in the cases of the Canadian PPNs in question but the upside is gone. This means you have basically locked in your money with close-to-zero return for the next 5 years (or whatever the period is.)

There is nothing illegal in any of this. I'm sure it's all in the legal documentation/prospectus but how many would have understood any of it? Many, including me, would not have expected Lehman Brothers unsecured bondholders to end up with almost nothing. If Lehman was a going concern, the unsecured claims are good and would be paid.


Exchange-traded Note (ETN)

While we are talking about investment risk, one should also be very careful with exchange-traded notes (ETNs). Unlike ETFs, ETNs contain credit risk of the issuer. An example of an ETN is the Barclays iPath MSCI India ETN (symbol: INP). Since India has capital controls and foreigners cannot easily invest directly in the market, there is no ETF and your only bet is an ETN like INP (or a closed-end fund like IFN; or to invest in foreign-listed stocks.) If Barclays goes bankrupt, not that I'm predicting that or anything, there is a risk that your ETN may be at risk. In contrast, if you own ETFs, there is no risk.

So should one completely avoid ETNs? The answer is yes but the problem is that an ETN is often the only way to invest in certain markets. As mentioned above, it would be almost impossible for foreigners to buy India-listed stocks (this is very important given that NYSE-listed Indian stocks have historically traded at massive premiums to locally-listed stocks.) Similarly, it would be very difficult to invest in commodities themselves without a structured product like an ETN. Similarly, it would be almost impossible to invest in a carbon index, as the iPath Global Carbon ETN (GRN) does.