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Regulators warn about principal-protected notes

Worried about the increasing number of retail investors jumping into complex financial products, securities regulators warned last week that structured notes with principal protection aren't risk-free

Worried about the increasing number of retail investors jumping into complex financial products, securities regulators warned last week that structured notes with principal protection aren’t risk-free.

The Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. said that such an investment may come with confusing terms that actually guarantee as little as 10% of the investment and limit the amount that investors gain on the upside. It also can tie up those funds for a decade.

Structured notes with principal protection combine a zero-coupon bond and an option whose payoff is linked to an underlying asset, index or benchmark, or a basket of benchmarks. The payoff can vary, based on the performance of the linked index, but the bonds offer the prospect of a greater return than money market instruments.

“The current low-interest-rate environment might make the potentially higher yields offered by structured notes with principal protection enticing to investors,” said John Gannon, Finra’s senior vice president for investor education.

Investors typically are interested in such products because they think that they are gaining possible market upside while protecting their principal.

LACK OF UNDERSTANDING

But the SEC says that principal-protected notes vary widely by issuer, and investors tend to ignore or don’t understand what is spelled out in prospectuses.

The problem with principal-protected notes is that the principal often isn’t protected, according to the SEC. Some sellers of the notes do indeed guarantee 100% of principal, which is fine, unless the issuer of the note goes bankrupt, in which case the investor likely will lose all or most of the principal.

In April, UBS Financial Services Inc. agreed to pay $10.75 million in fines and restitution to settle Finra allegations that its advisers misled clients about the “principal protection” feature of structured notes issued by Lehman Brothers Holdings Inc. that it sold a few months before that firm collapsed.

In its complaint, Finra said that some UBS advisers didn’t understand the complexity of the 100% principal-protected notes that Lehman issued, and failed to tell investors that they were unsecured obligations.

In settling the case, without admitting or denying the allegations, UBS said that it was pleased to have the matter resolved and that most structured-product sales had been done properly.

The SEC warned that other issuers of principal-protected notes guarantee only a certain amount of the principal, in same cases, as little as 10%. Sometimes the principal is protected only if a contingency stipulated in the prospectus is met.

Lori Schock, director of the SEC’s investor education office, said that anyone considering an investment in these products should read the commission’s alert, “especially those with the mistaken belief that these investments offer complete downside protection.”

Figuring out upside return can be complicated.

And investors also must hold these notes to maturity to receive the full payout, and those maturities sometimes run as long as 10 years.

Nevertheless, the market for structured notes with some form of principal protection reached $43 billion last year, a 54% increase over 2009, according to data-gathering firm StructuredRetailProducts.com.

E-mail Liz Skinner at [email protected].