Executive Summary
The retail market for principal-protected notes (PPNs) has grown in recent years, in part because they are often marketed as combining the relative safety of bonds with a potential for growth not available with traditional fixed income products. However, these products are not risk-free, and their terms and structures can be complex. Firms must ensure that their promotional materials or communications to the public regarding these products are fair and balanced, and do not overstate either the level of protection offered or an investment’s potential returns. Firms also have a duty to ensure that their registered representatives understand the risks, terms and costs associated with these products, and that they perform an adequate suitability analysis before recommending them to a customer.
Questions concerning this Notice should be directed to the Office of Emerging Regulatory Issues at (202) 728-8472.
Background and Discussion
PPNs typically combine a zero-coupon bond with an option or other derivative product whose payoff is linked to an underlying asset, such as an equities index or basket of indices. The investor is guaranteed the return of some or all principal at a set maturity date—typically ranging up to ten years from issuance—and also is entitled to participate in a return that is linked to a specified change in the value of the underlying asset.
PPNs sold to retail investors often have reassuring names that include some variant of “principal protection,” “capital guarantee,” “absolute
return,” “minimum return” or similar terms. However, they are not without risk. Most importantly, the principal guarantee is subject to the credit-worthiness of the guarantor. In addition, principal protection levels can vary. While some products guarantee 100 percent return of principal,others guarantee as little as 10 percent. In most cases, the principal guarantee only applies to notes that are held to maturity. Issuers may (but are not obligated to) provide a secondary market for certain notes but, depending on demand, the notes may trade at significant discounts to their purchase price and might not return all of the guaranteed amount.
