With interest rates dramatically falling in the fixed income market like municipal bonds and CDs, brokers have been offering sexy alternative investments to their customers. Often, clients come to us with these types of alternative fixed income products asking what exactly they invested in. The investment bankers at large brokerage firms are very savvy and adept at creating new types of investments and their brokers then go out and sell them to their customers. Although investments such as a principal protected note seem simple, often these tend to be quite complex. 

What is A Principal Protected Note?

According to the  Securities and Exchange Commission (“SEC”), a  “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

Generally, such investments contain inherent risks that the customers do not understand and which were not adequately explained by the broker or financial advisor.

Despite their Name, Principal Protected Notes are Risky

While on the surface principal-protected structured notes appear pretty vanilla, they are rather complex instruments.  These investments are enticing to the fixed income investor because they offer the possibility of earning much higher interest than traditional CDs or money market accounts. However, with those possible returns, there is also a risk. 

Some Common Risks of Structured Notes :

1. Credit risk. The credit risk is the risk of the entity that is backing the investment. The notes are not guaranteed by the government. They are backed by the credit of the investment bank or “issuer” of the note. Buyers bear the risk that the issuing investment bank might go under and not meet its payment obligation. In this case, the derivatives underlying the note can perform perfectly, but the note can still be worthless. This is what happened when Lehman Brothers collapsed and its principal-protected notes were no longer protected. As explained by the SEC, 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. 

2. Liquidity Risk. Liquidity is the ability to readily sell your investment in the market. Principal Protected  Notes have long maturity dates, meaning the date you will get you invested funds back. Maturity dates can be ten years or longer, which means you will not have access to your funds during that time. They are not like a  CD where you can get out with paying a penalty of earned interest. The only way to get your money before maturity is by selling in a “secondary market” to another investor or the issuer which means you may take a bath when trying to get your money.

3. Call Risk. Many notes have a call features meaning that the issuer could redeem the note before the maturity date, no matter what the price is. This means that you could be forced to sell your investment back at a lower than face value price. 

4. Taxes aren’t what you think. These notes are a debt instrument like a bond and investors generally pay annual taxes on them even though the note has not reached its maturity date and the investor has not actually received cash. There are also other ways you might be taxed or that tax event can be reported (like original issue discount or “OID”). 

5. High Commissions. You might be surprised at the hefty commission you are paying to your broker and the firm for the sale of one large product. The commissions are usually in the 3-4% range (check your prospectus) which can be very pricey on a large note purchase.

6. Pricing is not Reliable. After their sale, the pricing of Principal Protected Note is set by the issuer investment bank. The prices can be very different from the actual net asset value of the underlying investments so it’s anyone’s guess what it is really worth at any given time.

Have you lost money in a Principal Protected Note?


If you or a loved one have suffered investment losses as a result of an investment in a Principal Protected Note or any other type of investment fraud or broker negligence, contact the offices of Investment Fraud lawyer Melanie Cherdack for a free consultation. Because she has been in the trenches as a former Wall Street attorney, Melanie Cherdack and her team of experienced attorneys have seen just about every type of investment fraud or investment scam. While almost every investment carries a degree of uncertainty and risk, you may have been unnecessarily exposed to such risk. Former Wall Street securities attorney Melanie S. Cherdack and her team of lawyers represent individual and institutional investors who are unwitting victims of investment fraud and broker negligence. She heads up a group of attorneys who represent investors across the United States. Contact us by filling out our online contact form, or calling 888-768-2499 or 305-349-2336.