Will inflation finally doom the principal protected note?

Posted by admin on April 14, 2009 in Investment Products, Investment Strategy

The United States Federal Reserve recently commented that it wants the amount of inflation conducive to a recovery. I would file the Fed wanting the “right” amount of inflation under the same category as bankers saying circa 2002 that a little bit of above normal leveraging is acceptable (open Pandora’s box…now!). If, indeed, inflation is returning, does its return merely add another reason why the principal protected note is a bad investment choice?

To recall, a principal protected note (or guaranteed linked note) is a structured product which, theoretically, gives to the investor the upside of equity by linking a return to some basket of equities (an index, an industry etc.) while offering bond-like downside protection by guaranteeing 100% of the initial investment as long as the investment is held to maturity.

The issues of the principal protected note are well noted (high costs, investor is actually self-insuring, complexity etc. etc.- the best recent summary of the issues with principal protected notes is the Steady Hand’s blog on structured products). However, inflation risk was never highlighted as a plausible risk in a world of low inflation and inflation may yet undercut another pillar of the sales feature of principal protected notes.

Let’s step back 6 months. Many very complex principal protected notes have triggers known as “protection events.” In the event the performance of the equity side of the note was subject to a material adverse change (such as those seen in September 2008), the note, effectively, has an emergency brake and the entire portfolio converted into bonds and the investor is eligible to receive only the principal back upon maturity.

Is it that bad that one holds a principal protected note that will only return your principal? Better than losing your shirt right?

In the abstract, this is correct but the devil is in the details. Remember that you receive your principal back only if you hold the note to maturity (which, in many notes, is 3-5 years away). Assume the Fed cannot control inflation; a plausible scenario since the best way to control inflation is to choke off the money supply or raise interest rates- which are the last things you want to do when the credit markets begin to recover.

In 3-5 years, every dollar of principal returned will be worth a lot less than when one invested it in a principal protected note. In other words, a principal protected note is giving you less than what you invested once you factor inflation. The longer to maturity the note and the greater the rate of inflation, the less one’s return. Given that most principal protected notes do not guarantee principal indexed for inflation, an investor is not even reaping the full effects of downside protection.

Many investors invested in these notes by re-allocating from a fixed income portfolio. In hindsight, they would have been better off leaving their money in fixed income which at least are interest rate sensitivity (or, in a real return bond, inflation sensitivity) and not stacked with fees.

One should never under-estimate the ability of the financial institution to adapt and sell bad products under new names. I do not doubt that we may see a new generation of principal protected notes with the principal indexed for inflation but why pay for this feature when you could buy a real return bond that accomplishes the same goal without the fees?

…and, as mentioned by many others, stocks, over the long run, are your best protection against inflation.