An Introduction to Structured Products

Fact checked by Vikki VelasquezReviewed by Charles PottersFact checked by Vikki VelasquezReviewed by Charles Potters

Once upon a time, the retail investment world was a quiet, rather pleasant place where a small, distinguished group of trustees and asset managers devised prudent portfolios for their well-heeled clients within a narrowly defined range of high-quality debt and equity instruments. Financial innovation and the rise of the investor class changed all that.

One innovation that has gained traction as a supplement to traditional retail and institutional portfolios is the investment class broadly known as structured products. Structured products offer retail investors easy access to derivatives. This article provides an introduction to structured products, with a particular focus on their applicability in diversified retail portfolios.

Key Takeaways

• Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives.
• These products may take traditional securities such as an investment-grade bond and replace the usual payment features with non-traditional payoffs.
• Structured products can be principal-guaranteed that issue returns on the maturity date.
• The risks associated with structured products can be fairly complex—they may not be insured by the FDIC and they tend to lack liquidity.

What Are Structured Products?

Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives. They are generally tied to an index or basket of securities and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and replacing the usual payment features—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.

Origins

One of the main drivers behind the creation of structured products was the need for companies to issue cheap debt. They originally became popular in Europe and have gained currency in the United States, where they are frequently offered as SEC-registered products, which means they are accessible to retail investors in the same way as stocks, bonds, exchange traded funds (ETFs), and mutual funds. Their ability to offer customized exposure to otherwise hard-to-reach asset classes and subclasses make structured products useful as a complement to traditional components of diversified portfolios.

Returns

Issuers normally pay returns on structured products once it reaches maturity. Payoffs or returns from these performance outcomes are contingent in the sense that, if the underlying assets return “x,” then the structured product pays out “y.” This means that structured products are closely related to traditional models of options pricing, although they may also contain other derivative categories such as swaps, forwards, and futures, as well as embedded features that include leveraged upside participation or downside buffers.

Looking Under the Hood

Consider that a well-known bank issues structured products in the form of notes—each with a notional face value of $1,000. Each note is actually a package that consists of two components: A zero-coupon bond and a call option on an underlying equity instrument such as common stock or an ETF that mimics a popular index like the S&P 500. The maturity is three years.

The figure below represents what happens between issue and maturity date.

Although the pricing mechanisms that drive these values are complex, the underlying principle is fairly simple. On the issue date, you pay the face amount of $1,000. This note is fully principal-protected, meaning you will get your $1,000 back at maturity no matter what happens to the underlying asset. This is accomplished via the zero-coupon bond accreting from its original issue discount to face value.

For the performance component, the underlying asset is priced as a European call option and will have intrinsic value at maturity if its value on that date is higher than its value when issued. If applicable, you earn that return on a one-for-one basis. If not, the option expires worthless and you get nothing in excess of your $1,000 return of principal.

Custom Sizing

Principal protection offers a key benefit in the above example but an investor may be willing to trade off some or all protection in favor of more attractive performance potential. Let’s look at another example in which the investor gives up principal protection for a combination of more potent performance features.

If the return on the underlying asset (R asset) is positive—between zero and 7.5%—the investor earns double the return. So in this case, the investor earns 15% if the asset returns 7.5%. If R asset is greater than 7.5%, the investor’s return will be capped at 15%. If the asset’s return is negative, the investor participates one-for-one on the downside, so there is no negative leverage. In this case, there is no principal protection.

The figure below shows the payoff curve for this scenario:

This strategy would be consistent with the view of a mildly bullish investor—one who expects positive but generally weak performance, and is looking for an enhanced return above what they think the market will produce.

The Rainbow Note

One of the principal attractions of structured products for retail investors is the ability to customize a variety of assumptions into one instrument. As an example, a rainbow note is a structured product that offers exposure to more than one underlying asset.

The lookback product is another popular feature. In a lookback instrument, the value of the underlying asset is based not on its final value at expiration, but on an average of values taken over the note’s term. This may be monthly or quarterly. In the options world, this is also called an Asian option—distinguishing the instrument from a European or American option. Combining these types of features can provide attractive diversification properties.

Important

The value of the underlying asset in a lookback feature is based on an average of values taken over the note’s term.

A rainbow note could derive performance value from three relatively low-correlated assets like the Russell 3000 Index of U.S. stocks, the MSCI Pacific Ex-Japan Index, and the Dow-AIG Commodity Futures Index. Attaching a lookback feature to this structured product could further lower volatility by smoothing returns over time. When there are wild swings in prices, it can affect an investor’s portfolio. Smoothing happens as investors try to reach stable returns as well as some predictability in their portfolios.

What About Liquidity?

One common risk associated with structured products is a relative lack of liquidity that comes with the highly customized nature of the investment. Moreover, the full extent of returns from complex performance features is often not realized until maturity. For this reason, structured products tend to be more of a buy-and-hold investment decision rather than a means of getting in and out of a position with speed and efficiency.

A significant innovation to improve liquidity in certain types of structured products comes in the form of exchange-traded notes (ETNs), a product originally introduced by Barclays Bank in 2006. These are structured to resemble ETFs, which are fungible instruments traded like a common stock on a securities exchange. However, ETNs are different from ETFs because they consist of a debt instrument with cash flows derived from the performance of an underlying asset. ETNs also provide an alternative to harder-to-access exposures such as commodity futures or the Indian stock market.

Other Risks and Considerations

One of the most important things to understand about these types of investments is their complex nature—something that the lay investor may not necessarily understand. In addition to liquidity, another risk associated with structured products is the issuer’s credit quality. Although cash flows are derived from other sources, the products themselves are considered to be the issuing financial institution’s liabilities. For example, they are typically not issued through bankruptcy-remote third-party vehicles in the way that asset-backed securities are.

The vast majority of structured products are offered by high investment-grade issuers—mostly large global financial institutions that include Barclays, Deutsche Bank or JP Morgan Chase. But during a financial crisis, structured products have the potential of losing principal, similar to the risks involved with options. Products are not necessarily insured by the Federal Deposit Insurance Corporation (FDIC). If the company goes has problems with liquidity or goes bankrupt, investors may lose their initial investments. The Financial Industry Regulatory Authority (FINRA) suggests that firms consider whether purchasers of some or all structured products be required to go through a vetting process similar to options traders.

Another consideration is pricing transparency. There is no uniform pricing standard, making it harder to compare the net-of-pricing attractiveness of alternative structured product offerings than it is, for example, to compare the net expense ratios of different mutual funds or commissions among broker-dealers. Many structured product issuers work the pricing into their option models to avoid an explicit fee or other expense to the investor. On the flip side, this means the investor can’t know for sure the true value of implicit costs.

The Bottom Line

The complexity of derivative securities has long kept them out of meaningful representation in traditional retail and many institutional investment portfolios. Structured products can bring many derivative benefits to investors who otherwise would not have access to them. As a complement to traditional investment vehicles, structured products have a useful role to play in modern portfolio management.

Read the original article on Investopedia.