FINRA Alert: Structured Notes with Principal Protection

Structured Notes With Principal Protection: Note the Terms of Your Investment

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The retail market for structured notes with principal protection has been growing in recent years. While these products often have reassuring names that include some variant of “principal protection,” “capital guarantee,” “absolute return,” “minimum return” or similar terms, they are not risk-free. Any promise to repay some or all of the money you invest will depend on the creditworthiness of the issuer of the note—meaning you could lose all of your money if the issuer of your note goes bankrupt. Also, some of these products have conditions to the protection or offer only partial protection, so you could lose principal even if the issuer does not go bankrupt. And you typically will receive principal protection from the issuer only if you hold your note until maturity. If you need to cash out your note before maturity, you should be aware that this might not be possible if no secondary market to sell your note exists and the issuer refuses to redeem it. Even where a secondary market exists, the note may be quite illiquid and you could receive substantially less than your purchase price.

While structured notes with principal protection have the potential to outperform the total interest payment that would be paid on typical fixed interest rate bonds, these notes also might underperform a typical fixed interest rate bond and could earn no return for the entire term of the note, even if you hold the note to maturity. Their terms and structures also can be more complex than traditional bonds, making them more difficult for investors to evaluate. Finally, as with structured products generally, structured notes with principal protection may have hidden or imputed costs that can be relatively high and difficult to understand.

FINRA and the SEC’s Office of Investor Education and Advocacy are issuing this alert to make investors aware of these risks and to help them better understand how structured notes with principal protection work. The alert includes questions investors should ask when considering structured notes with principal protection and provides links to helpful resources, including a recent FINRA Regulatory Notice on these products. In particular, the terms related to any protections to or guarantee of your principal require a careful review.

What Are Structured Notes With Principal Protection?

For the purposes of this alert, the term “structured note with principal protection” refers to any structured product that combines a bond with a derivative component—and that offers a full or partial return of principal at maturity. Structured products in general do not represent ownership of any portfolio of assets but rather are promises to pay made by the product issuers. Structured notes with principal protection typically reflect the combination of a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product whose payoff is linked to an underlying asset, index or benchmark. The underlying asset, index or benchmark can vary widely from commonly cited market benchmarks to foreign equity indices, currencies, commodities, spreads between interest rates or “hybrid” baskets of various asset types. For example, a note might be based on the performance of an equally weighted basket composed of the Russell 2000, an exchange-traded fund tracking a real estate index, the Brazilian Real-U.S. Dollar exchange rate and the price of copper. These products are designed to return some or all principal at a set maturity date—typically ranging up to 10 years from issuance. The investor also is entitled to participate in a return that is linked to a specified change in the value of the underlying asset.

How Do These Notes Protect My Investment?

If you hold a structured note with principal protection until maturity, you typically will get back at least some—and perhaps all—of your initial investment, even if the underlying asset, index or benchmark declines. Be aware that protection levels may vary. While some products return 100 percent of principal at maturity, others return as little as 10 percent. In some cases, the principal protection does not apply unless some contingency is met—sometimes called “contingent protection”—so it may provide no protection at all, even if the sales materials suggest otherwise.

Also, any guarantee that your principal will be protected—whether in whole or in part—is only as good as the financial strength of the company that makes that promise. In other words, the principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. In the event the issuer goes bankrupt, investors who hold these notes are considered unsecured creditors and might recover little, if anything, of their original investment. This is what happened to investors who purchased structured notes with principal protection issued by now bankrupt Lehman Brothers Holdings.

How Do Structured Notes With Principal Protection Calculate the Return on My Investment?

Some structured notes with principal protection make periodic interest payments while others don’t. The return on your investment—over and above any principal guarantee and assuming you hold the note to maturity—will depend on a host of factors, including the method the issuer uses to calculate gains (or losses) linked to the performance of the underlying asset, index or benchmark (the “market-linked” returns), the note’s participation rate and any minimum guaranteed return.

Market-linked gains (or losses).  As with other complex financial products, there can be varying and often complicated methods of calculating a market-linked gain or loss. For example, one product might compare the change in an index at two discrete points in time, such as the beginning and ending dates of the note’s term (point-to-point). Another product might look at the index value at various points during the life of the investment, for example at annual anniversaries, and then compare the highest value with the value of the index level at the start of the term (high water mark). Some products base your return on the number of days during the holding period that the underlying index stayed above (or below) a pre-specified level (accrual)—or within a range of pre-specified levels (range). And still others use complex, conditional formulas that allow you to participate in some or all of the index’s gain up to a set level—but significantly limit your return if, at any time during the holding period, the index rises above that level (shark fin).

Participation rates.  A participation rate determines how much of the gain in the underlying asset, index or benchmark will be credited to the note. For example, if the participation rate is 75 percent, and the asset, index or benchmark increases 10 percent, then the return credited to your note would be 7.5 percent.

Minimum guaranteed returns. If a structured note with principal protection offers a “minimum guaranteed return,” be sure to carefully read the prospectus to understand how the issuer defines that term. In some instances, the term includes not only the principal guarantee but also a fixed overall investment return. For example, a note with 100 percent return of principal at maturity and a 2 percent minimum guaranteed return would pay out 102 percent of your initial investment at maturity, regardless of how the underlying asset, index or benchmark performed. In other cases, however, an issuer might use the term to refer only to the level of principal protection.

The bottom line for investors is that structured notes with principal protection can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth. In addition, depending on how the note is structured, the distinct possibility exists that you could tie up your principal for upwards of a decade with the possibility of no profit on your initial investment. While your principal might be returned at maturity, that might be all you get back after this lengthy holding period—and, in the meantime, inflation could erode your purchasing power.

The chart below illustrates a hypothetical example of one of the more complex pay-out structures, sometimes referred to as a “shark fin” pay-out.

Shark Fin Pay-Out Assumptions:

  • Principal protection of 10 percent of initial investment
  • 100 percent participation in index gains up to 40 percent, so the maximum return is 140 percent of principal
  • Automatic 110 percent return at maturity if the index gains more than 40 percent at any time during the life of the note


Shark Fin Pay-Out Structure Hypothetical

In other words, the performance of the underlying asset impacts what the investor gets as follows:

Underlying Asset Performance


As the shark fin hypothetical above demonstrates, a note might be structured in a way that your upside exposure to the underlying asset, index or benchmark is limited or capped, which is generally a tradeoff for offering the principal protection. Although it might seem counterintuitive, in the example above, a 40 percent gain in the underlying index results in the return of 140 percent of principal invested, while a 41 percent gain (achieved at any time) would automatically result in the return of only 110 percent at maturity. This shows why reading and understanding the terms of these notes is so important.


Can I Get My Money When I Need It?


Potential lack of liquidity is one of the disadvantages of structured notes with principal protection. These products tend to be longer-term investments, tying up your money for several years. Some issuers might allow investors to redeem their notes before maturity under certain circumstances, such as expiration of a “lock-up period” (a period of time during which you cannot access your funds), payment of a redemption fee or both. Other issuers might (but are not obligated to) provide a secondary market for certain notes. However, depending on demand, the notes might trade at significant discounts to their purchase price and might not return the full guaranteed amount. In addition, the value of the note before maturity might be difficult to calculate and can vary depending a wide array of factors (including prevailing interest rates and the volatility of the underlying asset, index or benchmark). You might also have to pay a penalty for early redemption, further reducing any return of your principal.

Be aware of call risk. Call risk refers to the possibility that the issuer could call or redeem your note before maturity. This generally happens when it is in the issuer’s—rather than the investor’s—best interest to do so, such as when interest rates fall. While the bond’s principal is repaid early, you might be unable to find a similar investment with as attractive a yield.

Do Structured Notes With Principal Protection Have Fees?

Yes, even if the sales materials suggest otherwise. Virtually every investment has either implicit or explicit fees, whether they are described as selling commissions or concessions, management fees, structuring fees, early redemption fees or by some other term.

What Other Costs or Tradeoffs Are Involved?

Depending on their terms and the way they are put together, structured notes with principal protection can have hidden or imputed costs, which in some cases may be relatively high. These stem from the way a product is “bundled” or “packaged.” At issuance, any given note will have an estimated fair value based on its structure. The issuer generally raises this value by a spread to arrive at the offering price of the product, which captures costs to the issuer associated with the note over its life, such as costs of hedging, as well as the issuer’s profit. The hidden costs of purchasing virtually any structured product include the possibility that you could have assembled a similar bundle of investments on your own at a lower cost—and potentially with higher returns. The maximum return of any particular structured note with principal protection will typically reflect (and account for) the issuer’s costs of manufacturing and maintaining the note as well as its own profit margin. These costs generally are not transparent to investors.

Other costs of investing in structured notes with principal protection include the opportunity cost involved with sacrificing a potentially higher yield to obtain some downside protection. It is also important to note that the principal protection generally relates to nominal principal and does not offer inflation protection. And, for any underlying investment that would ordinarily pay dividends, structured notes, like other equity or index-linked investments, typically exclude dividends.

How Are These Products Taxed?

In most cases, if you invest in a structured note with principal protection, you must pay federal taxes while you own the product, even before maturity or during any lock-up period and even if you haven’t received any cash payments. This can occur if the interest on the product’s zero-coupon bond holdings (resulting from the principal guarantee) is considered to be imputed interest for federal income tax purposes. You should read the tax consequences description in the prospectus and consult your tax advisor to know how a particular structured note might be taxed and when you must report any income or loss.

What Questions Should I Ask Before Investing?

When you evaluate a structured note with principal protection, be sure to do your research to find answers to the following questions, among others, or ask your investment professional:

  • How do I know whether this product is appropriate for me given my overall investment objectives?
  • What is the level of principal protection offered? There is a big difference between 100 percent return of principal and 10 percent return, or something in between. Know your protection percentage.
  • Are there conditions to the principal protection? For example, is the protection contingent on the occurrence of specified events?
  • What are the fees and other costs? Products offering principal protection can be expensive. You should pay particular attention to the fees of any product you invest in, including those that offer principal protection. Ask your investment professional to explain all of the fees and costs associated with the investment.
  • How long will my money be tied up? Structured notes with principal protection are meant to be held to maturity and are often designed for long-term investors. If you need your money back early, you could pay a significant penalty. Furthermore, any downside protection offered might only kick in after a long lock-up period—or it might require you to hold the note until maturity.
  • Can I sell or liquidate before the maturity date? While it is easy to turn many investments into cash, liquid markets for some structured products might not exist. If you need to sell your structured note with principal protection before it matures, you might have to do it at a price less than the amount you paid for it, or you may not be able to sell it at all. This is true even if the product has a ticker symbol or has been approved for listing on an exchange.
  • Is there a call feature? If so, be sure you understand what can trigger the call and when is the earliest the investment may be called. You will also want to ask your investment professional what might be your game plan in the event your note gets called.
  • Are potential gains limited? Some structured notes with principal protection may have limits or caps on the gains you can earn based on the performance of the underlying asset, index or benchmark.
  • What are the tax implications? You might wish to consult with a tax advisor to understand the consequences of any particular investment, including imputed interest and any foreign tax consequences.
  • How does the pay-out structure work? Is it possible to lose money, or not have any gain at all, even if the underlying asset, index or benchmark goes up? Purchasing a structured note with principal protection does not guarantee positive returns. For example, the underlying asset, index or benchmark might not increase in value—or even if it does, there may be conditions, which in some cases can be counterintuitive, that limit your gains. And, if the entity backing the principal protection at maturity goes bankrupt, you could lose your entire principal.
  • What unique risks will I take on as a result of being exposed to the underlying asset, index or benchmark?
  • What is the credit risk of the note? Remember that any principal guarantee is subject to the creditworthiness of the guarantor, which is generally the securities firm that structures and issues the note. Be sure to find out as much as you can about the financial condition of the issuer and read its disclosures as carefully as you would for any other bond investment.
  • What other risks are associated with this particular product? Be sure you understand how the derivative component of the note impacts the pay-out structure—and ultimately your return.
  • What other investment choices are available to me? Carefully consider what might be a good fit for you, and whether there are alternatives to the product you are considering.


Even the simplest sounding products can be pretty complex. Always read a product’s prospectus or disclosure statement carefully. If you can’t understand how the product works, ask your investment professional for help. If you still can’t understand the product, you should think twice about investing in it.

If you (or someone you know) have questions or concerns about your investments or other securities matter, please contact the Law Offices of Mitchell S. Ostwald at 916.388.5100 or email us at