Structured products are investment alternatives that typically combine a bond and a derivative where the return is linked to the performance of one or more underlying assets. Unlike traditional stocks and bonds, structured products give investors access to non-traditional return profiles, exposure to a wide range of underlying asset classes and ability to act on market views.
Introduction to structured products
Structured products typically consist of two components: (1) a bond/note and (2) a derivative.
The derivative component is most commonly an option. Options are based on the value of an underlying asset, such as stocks, bonds, commodities, currencies, interest rates, and market indices. You do not invest directly in the underlying asset(s) when purchasing structured products.
The two components combined create a unique return on investment that is linked to the performance of the underlying asset(s).
Structured products allow investors to express a market view (bullish, bearish or neutral) and gain exposure to a variety of underlying asset classes.
Illustrative example of a structured product
Why consider investing in structured products?
Diversify your portfolio through a wide range of underlying securities
Structured products act as a portfolio diversifier by providing exposure and access to derivatives and underlying asset classes that may otherwise not be readily accessible. Structured products can help to broaden your sources of returns without actually owning the underlying.
Protect your capital with built-in downside protection
Some types of structured products, like principal-protected notes, offer a minimum return equal to an investor's initial investment. This format provides a safety net for your invested capital regardless how the underlying asset performs.
Enhance your returns by taking on market views
Some types of structured products can provide an efficient way to target equity-like returns. Payoffs are dependent on specific scenarios and you can potentially enhance overall returns if the underlying asset(s) performs in line with your market views.
What are some types of structured products?
Structured products generally fall into two categories, principal-protected or non-principal-protected (i.e. fixed coupon notes). Principal-protected notes preserve your invested capital while non-principal-protected notes offer potentially higher returns on your investment but with higher risk. An example of each is illustrated below.
Principal-protected notes (PPNs)
What are PPNs?
PPNs are capital protection products. They are typically structured as a zero-coupon bond (a bond that pays no interest until it matures) plus a call option. The zero-coupon bond provides the principal protection while the call option provides the opportunity to participate in the movement of the underlying asset(s)’s value.
Who are PPNs suitable for?
PPNs are suitable for more conservative investors who have a lower risk tolerance but still want the potential to benefit from the performance of markets outside of fixed income (i.e. stock market). PPNs allow investors to preserve capital while offering upside participation.
Illustrative example of a PPN
What is an example of a PPN?
You invest $10,000 in a one-year PPN that offers a zero-coupon bond plus a call option linked to the S&P 500 index, on the basis that you believe the index will rise in value. This means that you pay $10,000 on day one and receive $10,000 back at maturity, regardless how the S&P 500 performs. Your payoff depends on the scenario at maturity.
What are the different scenarios?
- If the index rises in value at/above the strike price at maturity:
- You receive a return in addition to the principal repayment. The return on the index is (i.e. 15%) is multiplied by a participation rate (i.e. 120%) to determine part of the payoff.
- If the index decreases in value at maturity:
- You still recoup your $10,000 principal payment in full.
Fixed coupon notes (FCNs)
What are FCNs?
FCNs are non-principal-protected products. They provide investors with regular fixed coupons at rates typically higher than traditional fixed income products. Unlike PPNs, the principal amount is at risk in exchange for enhanced returns. The underlying asset(s) for FCNs is typically a stock or basket of stocks.
Who are FCNs suitable for?
FCNs are suitable for moderate to high-risk investors with a neutral to slightly positive outlook of the underlying assets. There is also the possibility of receiving physical delivery of the underlying asset(s) in a worst-case scenario, so FCNs are suitable for investors that are comfortable taking on that risk.
Illustrative example of a FCN
What is an example of a FCN?
You invest in a $10,000 one-year FCN with a monthly 1.2% coupon and put options linked to a basket of stocks, on the basis that you believe the performance of the underlying stocks will remain the same or rise slightly in value. You receive monthly fixed coupons and the performance of each underlying stock is evaluated on an “observation date.” This observation date is at regular intervals and is a period where the underlying stock prices are measured relative to (1) knock-out/autocall trigger levels, and (2) strike prices. Your payoff depends on the scenario at any given observation date and/or at maturity.
What are the different scenarios?
- At each observation date:
- If an underlying asset closes at/above the knock-out level, the FCN will be “redeemed early” and you receive 100% principal plus any last fixed coupon. If this happens, you will not be able to collect the full yield given the early redemption.
- If all underlying assets close below the knock-out level at an observation date, then the FCN simply continues to the next observation date and repeats until it reaches maturity.
- At maturity:
- If all the underlying assets are valued at/above strike level, you receive 100% of principal in addition to the last fixed coupon. This means you received your principal repayment in full in addition to gaining the full yield.
- If any of the underlying assets fall below strike level, you are obliged to receive physical delivery of the worst performing underlying asset in the basket at the strike price but also receive the last fixed coupon. This is a scenario where you will end up owning the actual underlying asset(s).
- If any of the underlying asset prices close at zero, you lose all your invested capital but still receive the last fixed coupon.
Get a deeper look into the terminologies used in FCNs
Structured products provide a wide range of investment solutions across the risk-return spectrum, from capital-protected structures like PPNs to higher risk structures like FCNs. Structured products offer you access and ability to capture enhanced returns that traditional securities may not be able to provide. You can take advantage of short-term market opportunities with structured products, acting on your market views and accessing non-traditional sources of returns that can complement your investment portfolio.
Source: Credit Suisse, HSBC, UBS
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