What are structured products made of?

Structured products are financial instruments designed to balance risk and reward by combining an option for performance with a bond for capital protection. But what exactly does this mean, and how do these components work together to create a unique investment opportunity? 🤔

Let's explore how they function, their potential benefits, and the risks involved, to help you determine if they could be a valuable addition to your investment portfolio.

🏗 A bond

A bond is a piece of debt issued by an entity seeking to raise funds, which pays interest to the holder. In the case of structured products, these interests are not directly paid out but are used to finance the optional part of the product. Since the bond will be repaid 'at par,' meaning at 100%, it ensures the capital guarantee of a Capital Guaranteed structured product.

If the product is 100% capital guaranteed, the amount invested in the bond base corresponds to the guaranteed capital amount minus the expected interest. The lower the capital protection, the smaller the portion of the invested amount dedicated to the bond.

☄️ An equity option

The optional part enables the product's return. An option is a contract that can be bought or sold, giving the right - in exchange for a paid or received premium - to buy or sell an underlying asset at a predetermined date and price. Thus, in an unfavorable scenario, the optional part can affect the capital protection.

Conversely, if the scenario is favorable, it allows for financing the product's return. However, it should be kept in mind that in a favorable scenario, the gain from the structured product may be capped.

💸 ... and fees

While fees are additional to the invested amount in most financial products, the fees for structured products are directly integrated into the initial capital and therefore impact the return. For example, if the total fees are 5%, only 95% of the starting amount will be invested in the product.

🧐 Where does the risk come from?

... from the equity option

In an unfavorable scenario, the optional component can lead to a partial or total loss of the invested capital, depending on the risk accepted at subscription. Therefore, the entire capital is not protected in the case of negative performance of the underlying asset.

... from the bond

The risk can also come from the bond part. Like any debt product, it involves credit risk, referring to a possible default or bankruptcy of the issuer. This risk can be assessed through the ratings of these issuers, which are publicly available.

🥇 Why do prices vary between issuers?

All issuers have a rating that takes into account their solvency. The lower the rating, the more rewarding the risk is for the investor. Another factor to consider is the issuers' liquidity needs, also called 'funding.' The more urgently a bank needs funds, the more attractive the coupons.

Finally, the traders' assessment of volatility and dividends varies between issuers - this is called marking. Regarding volatility, the trader will need to hedge, and the cost of hedging will depend on his marking of volatility. As for dividends, the trader will apply a more or less significant discount compared to the dividends announced by the company whose stock is the underlying asset of the structured product. The higher the discount, the less attractive the coupons.