Structured Products can generally be defined as savings or investment products where the return is linked to an underlying asset with pre-defined features such as maturity date, coupon date, or capital protection levels. They belong to the range of products which may be considered non-traditional investment methods or Alternative Investments. A Structured Product can be seen as a product package combination using three main components: a bond, one or more underlying assets, and financial instruments linked to these underlying assets which comprise the derivative strategy.
The Bond component
Depending on the investment objective of the structured product, the interest generated by the bond component is used to buy the derivative strategy component and either provide the capital guarantee; redemption of the invested capital at maturity is thus guaranteed by the issuer (unless the issuer defaults) or improve the return on a non-capital-guaranteed product.
The capital guarantee or protection is provided by the issuer or its guarantor, except in the case of default. It is therefore essential to check the quality of the rating attributed to the issuer by credit rating agencies.
The Underlying component
The mechanics of a structured product are well defined and use proven methods. For example, a product that is structured, or configured, to return the initial investment at maturity plus an interest payment (coupon) linked to the performance of an underlying asset, i.e. the S&P 500 index, over a 5-year period. For every $100 invested, $90 is used to return the initial investment at maturity. This is because the provider is able to “lock in” a rate of interest over 5 years sufficient to return the initial investment. Then, $10 is used to buy financial instruments which provide the performance element and generates the targeted yields.
The performance element will determine the final return: if the S&P 500 performance is positive at maturity, then the investor will receive 20% of this performance plus the initial investment. Otherwise, some or all of the capital will be returned. In cases where where the index under-performs, return of capital will still provide a higher yield than a corresponding return in equities within the same index: If the index under-performs, at maturity, the yields of equivalent equity portfolios would be less than the initial capital invested; whereas with a structured product, it is often possible to achieve full recovery of principal.
In the simplest case, an investor with $1000 to invest purchases a certain structured product. A Zero-Coupon bond is purchased at 90, at maturity, the bond returns $1000. The remaining $100, or 10% of initial principal would be the yield-generating component that is part of a derivative strategy. If the Index severely under-performs and goes into negative terrain, the investor still gets 100% of the initial principal at maturity. Alternatively, the investor who invested in a pure equity portfolio would have lost a significant portion of their initial investment. In this example, the investor with the structured product would have losses limited to inflation and opportunity costs. The pure-equity investor would have loss of principal in addition to losses from inflation and opportunity costs. With a positive Index, the investor with the structured product would immediately have greater percentage gains than a pure-equity investor.
The Derivative component
The “derivative strategy”, usually comprising options, is of paramount importance in the construction of a structured product. Most of the time it is what determines the level of return. The choice of derivatives 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.
Every strategy, from the simplest to the most complex, is based on the use of derivatives, most often in the form of options. Structured Products are available through different investment vehicles such as EMTN (Euro Medium Term Notes), and Certificates, all issued mainly by financial institutions. Structured Products are hence tailor-made solutions that can be adjusted to different market conditions and that entail different risks, which must be monitored.
In summary, structured products are an integrated product package which can provide investors with efficient diversification, some limited down-side potential, and an opportunity for significant gains.