The Basics of Principal Protected Notes

Principal protected notes are a type of investment that guarantees the original amount of principal for the investor. This type of investment provides regular investors with a way to get involved with hedge fund investment techniques. These are custom made investments that regular investors can take advantage of. This type of security is sold as a debt instrument that is guaranteed by a financial institution. Here are the basics of principal protected notes and how they work.

Principal Protected Notes

This type of security is created by a financial engineer by combining multiple investments into a single package. This type of security is distributed as a debt instrument to investors. The investment is backed up by a financial institution such as a bank in most cases. Since this type of investment is guaranteed by someone else, you have to make sure that you check out the financial strength of the bank that is issuing it. However, in most cases, this is considered to be a very safe investment.

This type of investment works a lot like a bond. You invest a certain amount of money at the beginning which is known as the principal. With this type of investment, an option will be used to provide additional upside. You have to agree to invest your money for a certain term of years. Generally, you will have to agree to leave your money in the investment for somewhere between five and 10 years. As long as you leave your money in the investment for the full term, you will be able to get your entire initial investment back.

Options

Unlike regular bonds, you will not receive coupon payments with principal protected notes. Instead, the option that is associated with your investment will determine how much you earn. If the option is worth something at the end of your term, it will be redeemed and this will act as the capital appreciation in your investment. If the option is worthless, it will be allowed to expire and you will only get your initial investment back.

Typically, they will use a certain percentage of your investment to purchase a zero coupon bond with the remainder of the investment going towards purchasing an option. The zero-coupon bond will then mature and provide you with the initial amount of money that you invested at maturity.

Pros

One of the big advantages of this type of investment is that your initial investment is guaranteed. This allows you to speculate in a particular market without risking losing your initial capital. Most investments cannot provide the best of both worlds like principal protected notes can.

Cons

This type of investment may not provide you with any returns over long period of time. You are essentially taking a risk when you invest in principle protected notes. If you would simply invest in a traditional bond, you would be assured at least some type of return and regular payments. With principle protected notes, there are no such assurances.

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