During times of market uncertainty, investors often seek capital guarantees but they do not want to give up the potential upside of any market returns. This is one of the main reasons why structured products exist. Many structured products provide a capital guaranteed plus a return linked to a market, commodity or other asset. But how are these made and could you do it yourself?
Making your own guaranteed product is relatively straightforward. Firstly, you need an asset that will provide the capital guarantee. Usually this is an investment grade bond. This may be issued by a country or a large multinational company such as a bank for example. The maturity of the bond and income paid over the term will generate the return of capital to the investor.
The amount of the investor’s capital invested in the bond at outset is determined by the term of the bond and the coupon (interest/profit) paid by the issuer of the bond. So, if the bond pays 1% per annum and has 5 years to run, roughly speaking 95% of the investors capital must be invested in the bond to generate 100% (95%+(5×1%)) in 5 years time. So that’s how the guarantee is secured, where does the return come from?
The 5% of the investor’s capital which is not invested in the investment grade bond is used to buy a derivative linked to the commodity or index in which the investor wishes to participate in, eg. S&P 500, oil, gold, FT-SE 100 etc and to pay the fees and expenses of setting up the structured product.
This is the easiest way of replicating a guaranteed investment however there are other ways banks achieve this result. For example, they can enter into insurance contracts that generate similar results.
The problem for most investors is the amount of capital you need to invest to achieve the same returns as the banks achieve, even after their fees are taken into account they have huge economies of scale on their side. Additionally, most investment grade bonds are only sold to financial institutions and in multiples of millions. Derivatives contracts, whilst only a small amount of the guaranteed product, do tend to have rather high minimum ticket size which takes them out of the grasp of most retail investors.
So when looking for a bank with whom you wish to hold a structured product, what are the risks? Apart from the risk that the investment element may not yield any return, there are default and counterparty risks. The provider of the investment grade bond may be AAA today but this may be subject to a downgraded or worse a default during the term of the investment. During the Global Financial Crisis many banks went bust, possibly the most famous was Lehman’s who guaranteed not just their own debts but also many third parties. If a default occurs your guarantee may seriously compromised or possibly worthless. The other risk is counterparty risk within the derivative contract. Every derivative is matched, meaning that there is another party on the opposite side of the derivative who stands to gain or lose antagonistically with you. If they fail to meet their side of the bargain you may not get the return you were expecting. Judging investment, default and counterparty risk in structured products is important.
I hope the above was useful, please let me know of you have any feedback or comments.