Understanding Structured Products
In an uncertain market environment, structured products may well be an attractive solution.
For the last few weeks, investors have had to deal with a market environment characterized by a high degree of uncertainty. As a result, many have been willing to invest but have hesitated and finally done nothing. Others have realized that Structured Products can be an efficient tool for investing in all asset classes, including fragmented or difficult-to-access markets, with tailored protection.
Without doubt, as investment solutions in their own right, structured products represent an original and effective alternative to the usual financial investments. They offer solutions that can be adapted to the needs of each investor, for example in terms of strategy, risk/return profile, maturity or the amount to be invested. They enable investments in a wide range of underlying assets (equities, interest rates, foreign exchange, indices, commodities ...) and offer various redemption possibilities.
Structured Products can therefore provide tailored solutions in line with a specific strategy in all market configurations. Whilst they are a useful tool for portfolio management and risk control, they are nonetheless very sophisticated. This sophistication is needed to meet the specific requirements of investors who each have their own investment profile and market knowledge.
What exactly is a Structured Product?
Structured Products can be loosely defined as a savings or investment products where the return is linked to an underlying asset with pre-defined features (maturity date, coupon date, capital protection level ...). They belong to the range of products with 'non-traditional' investment strategies. A Structured Product can be seen as a product package using three main components:
- a bond,
- one or more underlying assets
- financial instruments linked to these underlying assets (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" part 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
How does it work? Consider a product that aims to return the initial investment at maturity plus an interest payment (coupon) linked to the performance of an underlying asset, i.e. the Euro Stoxx 50 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.
- €10 is used to buy financial instruments which provide the performance element.
The performance element will determine the final return: if the Euro Stoxx 50 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.
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. As a conclusion, we can define Structured Products as an integrated product package, which can provide your portfolio with efficient diversification.