Structured products are financial instruments specifically designed to meet various objectives. Thanks to their flexibility, they represent an attractive alternative to the direct holding of other financial instruments such as bond, shares, currencies…
Their redemption and their potential profit are linked to the performance of one or more underlying assets. Depending on their desired goal, products can be designed to fit most market expectation (positive, stagnant, negative) and any risk profile.
Structured products also allow investors to get exposure to underlying assets usually complex to access to most investors, such as Credit Default swaps, commodities, hedge funds, risk premia and implicit assets classes such a volatility or correlation.
“Most of the time, structured products are built under the form of debt obligations payable by the issuers.”
Most of the time, structured products are built under the form of debt obligations payable by the issuers. The products constitute immediate, unsecured and unsubordinated obligations of the issuers, which, particularly in case of insolvency of the issuer, rank pari passu with each and all other current and future unsecured and unsubordinated obligations of the issuer, with the exception of those that have priority due to mandatory statutory provisions. If the issuer’s financial position were to deteriorate, there could be a risk that the issuer would not be able to meet its obligations under the products.
Structured products fall into broad categories and the terms used may vary from one issuer to the other.
EUSIPA (the European umbrella of LUXSIPA) intends to be a main supporter of the efforts for transparency and understandability of structured investment products. Thus, its members have agreed to set standards for a uniform categorization.
The Eusipa Derivative Map can be accessed on www.eusipa.org and also be ordered free of charges as printed versions in different formats. The categorisation differentiates the Capital Protected Products, Yield Enhancement Products, Participation Products and Leverage Products.
Like any financial products, structured products entail certain risks. An investor should be fully aware of these risks and ensure that he has a sufficient understanding of the key features of a product to make informed investment decisions.
Below are few risks that most of the structured products have:
The market price of a product may be affected by various factors, such as the time remaining to the maturity, the volatility and the dividend rate (if any) of the underlying asset or its components for a basket or an index, the movements in interest rates or the creditworthiness of the issuer and/or its guarantor.
An investment in the product is not the same as an investment in the underlying assets referenced by the product. An investor in the product has no ownership of, or rights to (including any right to vote and to receive dividends or other distributions) the underlying assets referenced by the product.
Structured products may contain a feature to reduce the downside market exposure to the underlying. Please note that any market risk reduction feature only applies at maturity. An investor willing to sell the structured product in the secondary market prior to maturity date may have to sell it at a loss relative to his initial investment, even if the investment would not have resulted in a loss at maturity. Few structured products do not have any market risk reduction feature, in which case the principal is fully exposed to any decline in the value of the underlying.
Structured product may pay fixed, contingent or variable interest, or may not pay any interest at all over its term. This interest, also named “coupon”, can be unconditional or conditional depending on the behaviour of the underlying. In general, the higher the interest rate for a structured product as compared to the yield payable on the issuer’s traditional fixed-rate bond with a similar maturity, the greater the risk of missing any contingent or variable-rate interest payments that may apply and/or of incurring a loss at maturity. For many income products, the return on the structured product is limited by the pre-specified coupon, without any exposure on the appreciation of the underlying. As a result, the return on an investment in the structured product could be substantially less than the return of a direct investment in the underlying.
Most structured products are issued as unsecured obligations of an issuer. Because the structured product is not backed by any collateral, any payment on these structured products, including any repayment of principal and/or any coupons depends solely on the ability of the issuer, or the issuer’s affiliates, to pay. Investors in structured products will then be exposed to the credit risk of the issuer. If the issuer becomes insolvent or cannot make the payments on the structured products for any other reason, an investor may lose some or all of his investment.
Additionally, many countries have begun implementing resolution provisions regarding their systemically important financial institutions. The general effect of these provisions is to allow regulatory authorities to attempt to minimize the impact of a failing institution on the broader economy and financial system. These types of provisions could allow the debt obligations of a bank, including its structured products, to be restructured, written-down or converted to equity, potentially resulting in a loss to investors. Because these types of provisions may be exercised even if the bank is not in bankruptcy or has yet to default, they must be considered in addition to traditional issuer credit risk.
Most issuers of structured products are evaluated for credit quality by Standard & Poor’s, Moody’s Investor Service, or Fitch Ratings. The lower the assigned rating is on the respective scale, the higher the respective rating agency assesses the risk that obligations will not, not fully and/or not timely be met. The rating gives a good indication but is based on financial conditions as of the Trade Date, and reflects only the rating agencies’ opinions. It is not a recommendation to buy, sell or hold structured products and may be subject to suspension, reduction or withdrawal at any time by the assigning rating agency.
While pricing models are based on recognized financial principles, every issuer, or the issuer’s affiliates, use its own proprietary models to price and/or hedge the structured products. As a consequence, any price quoted for the structured product by the issuer, or the issuer’s affiliates, may differ significantly from any price quoted by a third party or other market participants.
The tax treatment of structured products depends on tax laws and on the practice of the tax authorities that may change, possibly with retroactive effect. Any should consult with his tax advisors regarding the tax treatment of investing in any structured product.
Most of the time, the Issuer, or an affiliate, intends, under normal market conditions, to provide bid and/or offer prices for the products on a regular basis. However, the Issuer makes no firm commitment to provide liquidity by means of bid and/or offer prices for the products, and assumes no legal obligation to quote any such prices or with respect to the level or determination of such prices. Potential Investors therefore should not rely on the ability to sell a product at a specific time or at a specific price. There is usually a price difference between bid and offer prices (spread). Because other dealers are not likely to make a secondary market for the product, the price at which the investor may be able to trade the product is likely to depend on the price, if any, at which the Issuer or an affiliate of the Issuer is willing to buy the product. In special market situations, where the Issuer is completely unable to enter into hedging transactions, or where such transactions are very difficult to enter into, the spread between the bid and offer prices in the secondary market may be temporarily expanded. Hence, Investors might sell at a price considerably lower than the actual price of the Product at the time of its sale. By selling the products in the secondary market Investors may receive less than the capital invested.