If It Looks To Good To Be True...

April 11, 2006

Remember that banks don't give away money for free; why prinicipal protection deals aren't all they're cracked up to be.

Wall Street's product machine spits out new securities faster than we can analyze them. These innovations usually have one thing in common-despite their seeming appeal, they have attributes that make them more attractive to the seller than the buyer. The latest product is called a Principal Protection Note offered by JP Morgan Chase. It is another version from the general category called Equity Indexed Annuities of which we have written previously. The following is a brief summary of the product.

  • The notes are debt instruments-unsecured obligations of the bank.
  • The notes are linked to the change in the Dow Jones Euro Stoxx 50 and the Nikkei 225 Indices.
  • The payment is guaranteed to be no less than return of original principal (the bait, or trap), while providing a return that is linked to the changes in the two indices.
  • The return will be based on the LESSER of the change in EITHER index subject to a maximum return of principal plus 11.7 percent.
  • Maturity is March 30, 2007 (basically one year).

The following are the negative features:

  • As debt, the returns are ordinary income.
  • The return is based on changes in the indices, not the total return of an investment in the index. The difference is you don't earn the dividends.
  • There is no liquidity for the investment-no secondary market.

The attraction (bait) of the note is the guaranteed return of principal. The problem is that you give up far too much of the upside to obtain the downside protection. To illustrate the point we create a portfolio that is 50 percent MSCI EAFE ex-Japan (similar to the Stoxx Index) and 50 percent Japanese large stocks (similar to the Nikkei 225). The data covers the thirty-six-year period from 1970 through 2005.

  • This portfolio, with annual rebalancing, would have provided an annualized return of 12.1 percent-greater that the maximum return one can earn on the note.
  • The gains would be taxed at the advantageous capital gains rates.
  • There were eleven years (30 percent) when the principal protection provided by the note would have been required. In two of those years, however, the loss was less than 1 percent. If we eliminate those years (assuming an investor is not concerned about such a small loss) then the insurance was needed in nine of the years, or 25 percent of the time. 
  • The average loss during the eleven negative years was about 13 percent, and the worst loss was just over 24 percent. However, there were twelve years when the portfolio would have gained more than the worst single loss:

                * There were nine years with gains over 30 percent. 
                * There were four years with gains over 40 percent.
                * There were three years with gains over 50 percent
                * There were two years with gains over 60 percent.         
                * There was one year with a gain in excess of 70 percent.
                * There were a total of nineteen years (53 percent) when the portfolio gain exceeded the cap.
                * There were four years with gains over 40 percent.
                * There were three years with gains over 50 percent
                * There were two years with gains over 60 percent.
                 * There was one year with a gain in excess of 70 percent.

There were a total of nineteen years (53 percent) when the portfolio gain exceeded the cap.

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