Principal-protection notes

Asset prices have crashed globally due to the financial mess on Wall Street. It is in times such as these that asset management firms peddle products that allay investors’ fears and encourage them to regain exposure to the stock market.

One of our clients was recently offered such a product, similar in structure to the principal-protection notes (PPNs).

This article discusses the characteristics of PPNs, also called as capital-guarantee products, and shows why the plain-vanilla version may not be optimal for investors.

It also shows how asset management firms can custom-tailor products to enable investors fulfil their horizon objectives.

Principal-protection notes


The product plays on an important behavioural bias that Kahneman and Tversky called as the Prospect Theory.

These two psychologists found that people suffer more pain for losing money than they enjoy from gaining the same amount.

The PPNs moderate this bias by guaranteeing the return of capital. The guarantee, of course, comes at the cost of lower return.

Suppose an asset management firm offers a five-year plain-vanilla PPN for a minimum investment of Rs 25,000.

The portfolio manager will invest a proportion in zero-coupon (zeros) bonds and the balance in equity.

If the five5-year bond-equivalent yield is 10 per cent, Rs 15,400 will be invested in five-year zeros. This amount will grow to Rs 25,000 in five years to provide the capital protection.

The balance Rs 9,600 will be invested in an instrument that mirrors the Nifty index.

Some asset management firms provide a participation rate on the equity instrument. If the Nifty index moves up 10 per cent, a 75 per cent participation rate means that investor will receive only 7.5 per cent of Rs 9,600.

This plain-vanilla PPN is not an optimal investment. The reason is that the investor can replicate the payoffs at lower costs.

Of course, zeros are not available for retail investors. Such an investor can instead take 60 per cent exposure to a 10 per cent interest-bearing cumulative bank deposit and invest the rest in index funds. The exposure in term deposits will mature with a face value of Rs 25,000. The index funds provide a low-cost market exposure.

Replicating PPNs with cumulative deposits and index funds could generate a higher return for two reasons.

One, the investor gets 100 per cent participation on the Nifty index. And two, the cost of replicating the PPN structure (management fees) is lower.

Structured PPNs


Asset management firms can structure PPNs that carry exposure to select stocks or replicate payoffs custom-tailored to meet certain investment objectives.

Suppose a class of investors wants to buy a house five years hence. The primary risk is that house prices may go up in five years because of increase in real estate prices and/or hike in input costs such as cement and steel.

Assuming a five-year BEY of 10 per cent, the portfolio manager will invest Rs 15,400 for every Rs 25,000 in zeros.

The balance of Rs 9,600 can be used to take exposure in such stocks that help the investor hedge the risk of rising house prices.

This could mean exposure to the infrastructure sector. Specifically, the portfolio could contain stocks such as DLF, Tata Steel and ACC.

Of course, the assumption is that the rise in real estate, steel and cement prices would improve the revenue streams of these companies.

And that, in turn, will prompt the market to revise upward the asset prices of these companies.

As an alternative strategy, firms can also provide alpha returns on the equity exposure. Suppose the firm has an asset size of Rs 10 crore.

About 60 per cent would be invested in zeros at the five-year BEY of 10 per cent. The balance Rs 4 crore can be used to set-up a market-neutral equity portfolio.

Assume that the portfolio manager is positive on certain stocks in the mid-cap space.

The objective would be to take exposure to the excess returns that these stocks provide over the mid-cap index. An exposure to the select mid-cap stocks gives the portfolio manager two returns — mid-cap index returns (beta exposure) and the excess returns (alpha returns).

Buying select mid-cap stocks and shorting a certain number of mid-cap futures subtracts the beta exposure from these stocks. The residual returns will be the alpha returns- the objective of this strategy.

Conclusion


The sharp decline in asset prices in recent times encourages asset management firms to offer PPNs to investors fearful of regaining exposure to the stock market. This article shows that plain-vanilla PPN is not an optimal investment choice, as investors can replicate the payoffs at a lower cost.

It also shows how asset management firms could custom-tailor exposure to suit investors’ needs. Such products may carry high management fees but could enable investors achieve their horizon objectives.