Structured products are investment vehicles manufactured by financial institutions such as banks and insurance companies to offer the investor a simplified and packaged investment solution. These structures contain several different financial instruments combined to provide specific risk and return objectives.

 

The market for structured products as grown significantly in recent years, fuelled in no small part by the rise in popularity and availability of derivatives. These products are marketed to cautious investors who like the security of cash but want equity linked returns by participating in a market.

 

Under the Bonnet

 

A simple product might combine a ‘zero coupon bond’ to provide the capital protection, with a ‘call option’ on an underlying equity instrument to provide a return linked to market participation.

 

Capital protection

 

A ‘zero coupon bond’ is a fixed interest security that does not pay a coupon, instead it is sold at a discount so that on maturity, the investor receives the full face value with the profit being the difference between the discounted purchase price and the redemption price at face value.

 

Assuming the issuer of the bond is still solvent and able to redeem the bond at maturity; the investor is guaranteed to receive the face value. A 5 year zero bond with a face value of £1,000 might be sold for £800, i.e. with a £200 discount.

 

Performance

 

£200 would therefore be available at outset for the purchase of a call option to generate the desired returns. The option, typically priced as a ‘European call option’, will have intrinsic value at maturity if the underlying asset’s value on that date is higher than its value when issued – e.g. share price in a FTSE100 ETF. If not, the option expires worthless and the investor gets nothing in excess of the £1,000 return of principal from the bond.

 

Inflation would have eaten away at the original capital, but there is no risk of the sorts of losses felt by investors during an equity crash. The comfort of “at least your money back” is enough for many investors.

 

Charges

 

Product: Charges are generally implicit in the product. The set up costs are usually taken from the remaining capital after discount, i.e. £200, before the option is purchased.

 

Advice:

 

A Financial adviser will normally charge a fee for the advice and implementation of a strategy involving structured products. 

 

Liquidity

 

Most products will not allow the investor to withdraw the capital within the specified period. If the product is designed to run for 5 years, the invested capital must remain for the entire duration. This renders many structured products unsuitable for those wanting access to their money during the term of the investment.

 

Counterparty risk

 

The investor should take care to consider the financial security including the credit rating of all counterparties involved. If the issuer of the bond is not able to honour the face value of the security then the product would fail. Equally if the provider of the call option does not honour the derivative when called upon, the product will not deliver the promised upside.

 

Summary

 

It should also be noted that the above example and points summarise only one particular way to structure a product that is commonly found on the market today. There are many ways to combine other financial instruments to create the ‘structure’, including bank accounts and unit trusts.

 

Structured products might seem like a convenient and safe way to invest, however as you can see there are complexities to understand and be comfortable with before committing any capital. Many products offering a ‘capital at risk’ option will have even more generous promises of returns if all goes well and therefore seem very tempting options, so understanding what the potential losses are here is even more important.

 

It should also be noted that the above example and points summarise only one particular way to structure a product that is commonly found on the market today. There are many ways to combine other financial instruments to create the ‘structure’, including bank accounts and unit trusts.

 

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