Structured ProductsStructured products are investments that combine bonds and equities with derivatives – instruments whose value is derived from futures and options to buy, rather than from a physical asset.
This makes them potentially lucrative and relatively diverse, and an increasingly important part of the financial marketplace. Even so, their complexity leads many investors to avoid them.
The products can be made up of I) traditional investments such as stocks and bonds, II) non-traditional investments such as hedge funds, foreign exchange and commodities and III) financial investments such as options and futures.
We recommend structured products for sophisticated investors who are looking to diversify their portfolio but still require a level of protection. They may not be suitable for inexperienced investors and we therefore recommend to consult a financial professional to evaluate each product’s risk profile.
In my experience, the majority of people who ask about structured products are between 30 and 75 years old, male or female, who feel they have invested sufficiently in mutual funds, pensions and property and are ready to include something more adventurous.
Capital protected products
A mix of the aforementioned products creates an opportunity to profit from short-term market opportunities as part of a long-term strategy. For example certain combinations can allow the investor to take advantage of upward (or downward) movements in the market while providing partial or full capital protection.
For example it is possible for an investor to face no downside risk over the lifetime of a product, but to take part in 100 per cent of any upside performance.
This can be achieved by purchasing a zero coupon bond – which makes no regular interest payment during its lifetime, but is issued at a discount against the payout at maturity – and using the discount from nominal value to purchase a ‘call option’ or option to buy. The zero coupon bond matures at par, thereby guaranteeing the investor’s capital, while the call option maintains the upside exposure required.
For the inexperienced investor, a capital protected product is often the best way of getting to know structured investments. The degree to which an investor participates in the performance of the financial asset, and the risk to capital invested, will vary from product to product. This will largely depend on the maturity profile, forward interest rates, plus the yield and volatility of the currencies, bonds, equities, equity indices, or precious metals, on which the asset is based (ignoring any foreign exchange considerations).
Structured products allow you to invest according to future market scenarios, and can provide an excellent return if these scenarios unfold.
Furthermore, you do not necessarily have to take on additional risk or alter your current investment strategy. Derivatives can easily be incorporated into an existing investment strategy.
Some structured products offer capital protection at expiration as well as fixed interest payments, and can thus be equated with fixed-income investments such as money market instruments or bonds. Investors relinquish a part of their interest income to exploit a particular market situation.
Other types of structured products offer the opportunity for above-average capital gains, and are thus more comparable with equities.
Advantages
Structured investments can be used to:
- Replace underperforming investments and enhance returns
- Diversify a portfolio
- Access investment strategies not typically available to individual investors
- Manage risks and taxes
Risks
These can include but are not limited to:
- Price fluctuations of the underlying investment
- Substantial or complete loss of the principal investment
- Liquidity restrictions
- Credit risk (Issuer)
- The limited participation in the upside of the underlying investment (Don’t forget the use of a structured product is not equivalent to a direct investment in the underlying investment)
- Due to the complexity the extent of risk may not be adequately explained or understood.
Let’s take a brief look at two products from Switzerland’s leading banks.
Credit Suisse: Capital Protected Unit (CPU)
The CPU is a structured derivative that is a defensive alternative to a direct investment in the corresponding underlying. In the event of positive performance of the underlying instrument, it gives investors the possibility to earn higher returns than would be possible with comparable fixed-income instruments, as well as capital protection at maturity (generally between 90-100 per cent).
The CPU consists of two main components. The first, a zero-coupon bond, ensures the minimum redemption at maturity. The second, the option component, makes it possible to participate in the performance of the underlying at maturity.
Influence of interest rates
To achieve the protected minimum repayment at maturity, a large proportion of the money invested in the CPU is invested in a zero-coupon bond with the same maturity. This bond does not pay any coupons. Instead, all payments are included in the repayment at maturity. The interest rate sensitivity of such bonds (duration) is higher than that of traditional coupon paying bonds and corresponds precisely to the remaining time to maturity.
Like those of all bonds, the prices of zero coupon bonds move in the opposite direction to interest rates. Their prices fall when interest rates rise, as the future capital payment is discounted at a higher rate, resulting in a lower present value. The higher interest rates are, the lower the present value of the minimum repayment. As a result, the price of the CPU drops when interest rates are rising, and increases when interest rates are decreasing.
Influence of the underlying
The performance of the underlying influences the option component of the CPU, which determines the participation at maturity. However, the price's sensitivity to a positive performance of the underlying instrument during the lifespan is relatively limited.
Investors only profit from the positive performance of the underlying at maturity. As a result, particularly if the underlying instrument rises sharply at the beginning of the lifespan, there remains a certain likelihood that any negative performance posted by the underlying prior to maturity of the Note will reduce the profits again. Moreover, profits are only reflected in the current price on a discounted basis, since they will only be distributed at maturity.
On the other hand, sensitivity to a falling underlying is low too and even decreases in the event of consecutive plunges. Once it has reached a certain level, the note barely reacts at all to further losses, and investors benefit from the capital protection.
Conclusion
The CPU is comprised of components that are influenced by both interest rates and the underlying. Even when the underlying is stable, the price of the CPU can still vary considerably due to changing interest rates. However, interest rates have less of an impact on the price of the CPU as the maturity nears, because the minimum repayment becomes more significant as the remaining time to maturity declines.
In contrast, the sensitivity of the CPU's price to the underlying increases as maturity nears. Investors who are prepared to accept slow participation in the underlying's performance at the beginning of the term have the potential to achieve attractive returns at maturity.
UBS AG: Guaranteed Return of Investment (GROI)
This is a structured product combining a fixed-interest investment (capital protection component) with an option strategy (income-producing component). The degree of capital protection set on issue determines the minimum amount that is repaid to you at the end of the GROI‘s term.
However, it should be kept in mind that the capital protection does not apply during the term of the GROI, but only when it matures. GROI’s have an income-producing component that is also determined when the product is issued. This defines the extent to which the investor may participate in the performance of the GROI’s underlying and the maximum payment on maturity.
One of the features of GROIs is the fixed participation rate that, depending on the product, can be more or less than 100 per cent. The rate determines to what extent the investor may participate in the performance of the GROI’s underlying.
Important
The aforementioned products are complex and can involve a high risk of loss. This article does not take into account the particular investment objectives, financial situation and needs of individuals. Before entering into any transaction, an investor should determine if the product suits his or her particular circumstances and should independently assess (with a professional advisor) the specific risks (maximum loss, currency risks, etc.) and the legal, regulatory, credit, tax and accounting consequences.
