Structured products did not have a great start in the UK retail market, and they still struggle to shrug off some unbecoming misconceptions. The legacy of “precipice bonds” still sends shivers down the spine. In the right hands, however, structured products can be an invaluable part of your portfolios.
To understand a structured product you first need to get to grips with a zero coupon bond. This is, as it says on the tin, nothing fancier than a bond that pays no interest. As recompense for the lack of interest payments, a zero coupon bond is priced at a discount to its final redemption value: all the return comes in the form of capital growth. Unless the issuer goes bust, you know for sure that you will receive a certain amount of money on a certain day.
For example, you may pay £80 today for a bond that will repay £100 in five years’ time. The creator of a structured product can thus take £100 and buy £80 worth of this bond, knowing that they are sure (again subject to the bank, or “counterparty” not going bust) to have £100 in five years. This then gives them £20 left over to buy some option contracts to add exposure to the stated index or theme. In its simplest form, a structured product is no more than the packaging together of a bond and a derivative contract. The bond element provides the capital protection, the options element provides the sauce.
This can all go awry when excessive greed kicks in. It is a truism that an attempt at greater returns involves greater risk-taking. In the case of so-called “precipice bonds”, this was to the extent that the entire capital value could be put at risk, in return for a turbo-charged income. This is not a problem per se, but it becomes a big one when the bond is sold (on high commissions) to those unable to afford the losses, without the risks being explained, and just before a market crash.
The other issue, as we have said, is that of your counterparty. If there is one thing that we have all learned in the past decade it is that banks can go bust. There is an imbedded risk in structured products that your counterparty is unable to repay either the zero coupon bond or the pay-off from the option contract.
Beyond this, there is a whole new world of jargon to overcome. The user of structured products must understand the difference between European and American options, what a soft protection level is, how a “kick out” or an “autocall” works, the vagaries of capped and uncapped participation, multi-index correlation, implied and observed volatility, credit default swaps and even what a “Phoenix” is. And that is just for starters.
But it is worth the effort. Once you can get to grips with structured products, a whole new world of opportunity opens. The potential structures and uses are near-unlimited. What price would you put on the opportunity to make a double-digit return even if equity and bond markets fall? This can be done for less risk than the equity market and with the likelihood of getting your money back in the worst case scenario. In the world of structured products, a lot of effort goes a very long way.