Structured Products
What is a “Structured Product”?
Structured products can be defined as savings or investment products whose returns are linked to an underlying asset with predefined features. The maturity and coupon dates are examples of predefined features. Structured products are a broad category of financial instruments that investors can use to benefit from price movements in certain underlying assets, often only with a relatively small investment. They are generally linked to an index or basket of securities and are designed to ease highly customized risk-return objectives. This can be accomplished by taking a traditional security like a conventional investment-grade bond and replacing its periodic coupon payments and final principal with non-traditional payoffs derived from the performance of one or more underlying assets rather than the issuer’s cash flow. Structured products are designed for investors who are prepared to invest for a fixed period and who also want some degree of protection over their initial capital. They are generally issued by large financial institutions such as Goldman Sachs and BNP Paribas.
Key Learning Points
- Structured products are pre-packaged investments that typically include assets linked to interest in addition to one or more derivatives
- Structured products can be capital-protected, leverage, or yield-enhancement products
- Structured products lack liquidity because they are highly customized investment products, and their returns are not realized until maturity
- The three main components of a structured product include a bond, one or more underlying assets, and a derivative linked to the underlying assets
Understanding Structured Products
Structured products offer solutions that can be adapted to the needs of each investor, for instance, in terms of strategy, risk/return profile, maturity, or the amount invested. They also offer investors access to investments in a wide range of otherwise hard-to-reach asset classes and subclasses. This makes them useful complements to traditional components of diversified portfolios. Structured products originally came into existence through a need for companies to issue cheap debt and are now frequently offered as SEC-registered products in the United States. Structured products are accessible to retail investors in the same way stocks, bonds, exchange-traded funds (ETFs), and mutual funds are.
The issuer usually pays returns on structured products once they reach maturity. The returns are contingent in the sense that if the underlying asset pays ‘x’. The structured product will return ‘y’ making them closely related to traditional option pricing models. Structured products may contain other derivative categories such as swaps, forwards, and futures, and embedded features that include leveraged upside participation or downside protection.
Structured products lack liquidity because of their highly personalized nature and returns are realized only at maturity. These two characteristics make them more of a buy-and-hold investment decision rather than a means of getting in and out of a position with speed and efficiency.
A structured product can be seen as a product package that uses three main components: a bond, one or more underlying assets, and a financial instrument linked to these underlying assets (derivative strategy).
- The Bond component
The investment objective of the structured product may entail that the interest generated by the “bond” component be utilized to purchase the “derivative strategy” component. In addition, it can be used to either provide the capital guaranteed, that is, the guarantee of redeeming the invested capital at maturity by the issuer unless they default, or improve the return on a non-guaranteed product. The capital guarantee or protection with an exception in the case of default. Therefore, it is imperative to carry out due diligence to be cognizant of the issuer’s credit rating before investing in this category of products.
- The Underlying component
Suppose a structured product aims to return the initial investment at maturity in addition to an interest payment (coupon) which is linked to the performance of an underlying asset such as the S&P 500 Index over five years. For every $100 invested, $90 is used to return the initial investment at maturity. The issuer can realize this because they can “lock-in” a rate of return over the five years sufficient to return the initial investment. This permits the issuer to use $10 to buy financial instruments that provide the product’s performance element. The performance of the underlying component will determine the final return realized. If the S&P 500 Index has a positive performance at maturity, then the investor will receive 20% of this performance plus the initial investment. Contrarily, some or all of the initial investment will be returned with no additional return.
- The Derivative component
The derivative component, which generally consists of options, is the most important element of a structured product. In most cases, this component determines the level of return from the investment. The choice of derivatives used will depend on the desired risk level for the product ( capital protection or not), the preferred investment horizon, the type of return and exposure sought, and market conditions. All strategies ranging from the simplest to the most sophisticated are based on derivatives, with options being the most common type employed.
Types of Structured Products
Leverage products – accelerated returns
Leverage products offer higher participation with respect to the underlying asset than a direct investment. This is a leveraged form of yield enhancement that involves taking an increased degree of capital investment risk. It is achieved by using the premium derived from the sale of an option strategy to increase participation. The underlying products will contain option or credit exposures embedded within the structured product and the simple capital-protected products which enables the potential for enhanced returns at the risk of partial or complete capital loss.
Leveraged forms of yield enhancement can be achieved by investing in products with barrier features or products with combinations of barrier and early maturity features or increasing the level of capital investment exposure to 50% or 100%.
Capital protected products – swapping coupons for upside
Capital-protected products offer a minimum return of the initial capital invested plus a potential upside linked to the equity market at maturity. There are two basic pricing alternatives; (1) a zero-coupon bond plus an option combination, or (2) an interest rate swap plus rolling short-term deposits plus an option combination.
The traditional way of building a guaranteed equity product would be to split the investment received into two main blocks: (1) the upfront deposit, also known as the zero-coupon bond, which is guaranteed at maturity so long as the issuer does not default on their obligations, and (2) an option premium used to purchase at-the-money call options on an agreed underlying asset offering upside exposure.
At maturity, if the underlying asset performs positively, the investor realizes a return consisting of the guaranteed deposit on the zero-coupon bond and the difference between the strike price and the final price of the index. On the other hand, if the index does not perform as expected, the option expires worthless, and the investor is paid only the guaranteed deposit on the zero-coupon bond.
Yield enhancement products – simple yield enhancement
Yield enhancement is achieved in traditional investments through leverage, usually in the form of borrowing to finance additional exposure. In the case of structured products, this is achieved by limiting performance or accepting some degree of capital investment risk. These strategies can commonly be employed by being short volatility, selling an option strategy that allows the investor to use the resulting premium to feedback into the structured product.
Simple forms of yield investment can be achieved by capping or limiting the maximum achievable return, taking a limited capital investment exposure, taking a higher degree of credit exposure to the product issuer, or investing in products with early maturity features.
Conclusion
The sophistication of derivative securities has contributed to their exclusion from investment portfolios of both retail and institutional investors. Structured products have provided access to derivative benefits to investors who otherwise would not have access to them. Investors can increase their exposure to higher returns by taking part in such products combining traditional investment vehicles and derivative strategies while potentially facing higher risks. However, investors have to be informed about the credit quality of the issuer to assess the potential of default risk resulting in a loss of some or all of their initial investment. Structured products are tailor-made solutions that can be adjusted to different market conditions and entail additional risks. They are an integrated product package that can provide an investment portfolio with efficient diversification.
Below is a multiple-choice question to test your knowledge. Download the excel exercise sheet attached to find a full explanation of the correct answer.
