Rethinking Principal Protection

Abstract

A “principal-protected” note is a common design for structured product offerings. It is often marketed as a conservative and prudent approach to buffer against a complicated or risky market exposure. In practice, a “principal-protected” note is made up of two underlying components: a zero-coupon bond and a call option. Thorough analysis of these notes suggests that investors might benefit significantly from acquiring and managing the two underlying components independently. This unbundled approach likely improves the market and credit risk profile of the strategy, as well as enhances the liquidity, transparency, fee, and tax aspects. Finally, it readily allows for the consideration of alternative tools to best address a particular investor's objective.

TOPICS: Fixed income and structured finance, credit risk management, performance measurement