The Case Against Principal Protected Notes

The Case Against Principal Protected Notes

With the stock market at its all time high, brokers at Merrill Lynch, Morgan Stanley and JP Morgan Asset Management are touting an instrument called “principal protected notes.”  These notes come in a variety of different forms, but the structure is usually pretty similar.  You buy a note with a 100 par value tied to an S&P price that is set on the day of pricing.   If the S&P were to be trading at 2500, that would be your S&P price.   At the point of maturity, usually 5 years, you receive a percentage of the increase in the value of the S&P (usually between 50% and 70%) with your total appreciation usually capped around 30%).

These things are actually selling like hot cakes, especially now that the market is at its all-time high.   Brokers will tell you that you are not putting your principal at risk (which is correct so long as the underlying offeror does not default).  The notes, therefore, are very attractive to people who are risk averse and are upset that they have missed a huge run in the stock market.

Even if fear of missing out (FOMO) is your issue, this is not the right instrument for you.

Proper investing and proper financial planning involves having a portfolio of equity, debt securities, cash and other instruments (such as real estate, gold or other commodities).  

If you purchase one of these instruments, you are buying something other than equity.  Rather, you are buying an instrument that does not let you fully participate of the market, instead only giving you fractional participation, and that does not provide you with the dividend income on the S&P 500, currently about 2.2% annually.  That 2.2% dividend yield, when compounded, is roughly 11.5% over a five-year period.  Foregoing that yield is your "cost" of hedging the offeror's downside exposure in the instrument, but it is also cash out of your pocket if you have a long-term intention to stay invested in the market.

Likewise, the idea that your purchase of principal protected notes is just as good as cash if the market is lower in 5 years is also erroneous.  Your cash – if left in cash - will compound over the 5-year period no matter where interest rates go.  But, with interest rates poised to rise in 2017, 2018 and beyond, your cash could potentially compound at quite a high rate.  Even if you were to lock into a 5-year CD today (the best rates are currently just over the 2.2% S&P dividend yield), you are certain to see a compounded return over the life of the CD of just over 11.5%.

You need cash and you need equities.  A principal protected note is neither.

Explore the best savings rates and CD rates on BestCashCow.

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