Structured products are hybrid instruments created to meet specific needs of the investor with a customised asset mix. These typically include the use of derivatives which value is derived from an underlying asset being equities, shares, bonds, indices or any other financial assets.
Investment solutions in their own right, structured products can vary in their scope and complexity. This type of investment products are based on a traditional security, such as an investment grade bond, and replaces the usual payment features of the product (such as periodic coupons and final principal) with non-traditional payoffs, derived from the performance of one or more underlying assets rather than the issuer’s own cash flow.
A simple way of designing structured products is by purchasing a zero coupon bond (issued at a discount to par i.e. at a price lower than the maturity value) and use the remaining cash to buy an option, as explained below. The capital protection element is derived from the appreciation of the zero coupon bond expected to pay €100 on maturity while the return on the product is based on the actual value of the option once the product matures.
Only after a detailed assessment should such products form part of the portfolio
One of the key benefits of this product type is diversification which is generally not offered by other traditional asset classes. Other benefits depend on the type of structured product as each product features may vary, however these may include principal protection, low volatility, tax efficiency, provide greater returns when compared to direct investments in the underlying asset, or positive yields in low yield environments.
These products may also offer retail customers the possibility to improve portfolio returns in negative markets in two ways. The first, and most important, is the capital protection if product is held until maturity (percentage of capital protection can vary depending on the product’s terms and conditions), while the other being performance/return, by way of possible periodic coupon payments or participation in the overall performance of the underlying asset.
As expected these investments have some disadvantages too. These products are considered to be complex, therefore may not be available to all clients due to the required knowledge and experience. Products also carry a credit risk equal to the investment bank issuing the product; this is known at inception. It is imperative that the issuer is of a high credit rating. Furthermore, although a secondary market might be provided by the issuer, liquidity is usually low, so investors must accept the market price quoted by the issuer otherwise should be prepared to hold the investment till maturity.
An appropriately selected spectrum of such products can restructure a portfolio both in negative as well as in positive markets. The maximum benefit here for the retail customer is downside performance protection and indirect accessibility to investment vehicles which are not available to the normal retail investor.
Customers must have adequate knowledge and experience to understand primarily the mechanism and then, as a result, assess the feasibility and strategy being proposed. Only after a detailed assessment, should such products form part of the portfolio. It is recommended that investment advice is sought before accessing such type of investments in order to make sure that they have a fit within the customers’ objectives and risk profile.
Alex Bezzina is head of advisory investment services within BOV Wealth Management.
This article is not, and nothing in it should be construed as an offer, invitation or recommendation in respect of investment products or services offered by the BOV Group. Value of investments may go down as well as up and may be affected by changes in currency exchange rates. Past performance is not a guide to future performance.