Principal protected notes are a bit of a misnomer.

Photo: conorwithonen, Creative Commons, Flickr

A principal protected note involves a guarantee of your initial investment (principal) while still giving you some upside if a particular asset or price moves. For example, you could invest $10,000 in a principal protected not indexed to the Dow Jones Industrial Average for 5 years. For every percent the Dow goes up you would get a percent of return on your note. In other words, if the Dow is up 50% over fives years (goes from today’s 11,000 to 16,500)) then you would get back $15,000 ($10,000 plus 50% of $10,000). If the Dow goes down, you get back your $10,000 no matter how much it goes down.

All this is great as long as the issuer of the note is around in five years to pay you. Unfortunately, the principal and any upside is only guaranteed by the issuer and not some higher class entity like the government. If you bought principal protected notes from a now bankrupt investment bank, you are in line with the rest of the creditors to collect the principal protection that is due you. That is not the safe instrument you thought you were buying.

Disclosure: I am a former Managing Director and shareholder of the now bankrupt Lehman Brothers Holdings. I am not happy about losing a significant portion of my net worth to that bankruptcy. I own one principal protected note issued by JPMorgan Chase that is indexed to a basket of emerging market currencies.

Hat Tip: Steve Kurtz