What are Structured products and how do they work?

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08-Dec-2020 22:49:19
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Times have changed, and so has the Retail investment arena. Traditional investments like Gold and Bank deposits are no longer able to beat inflation, grow wealth or sometimes even protect capital. 

With the prevailing low-interest-rate environment and high market valuations, there is a distinct need for investment vehicles offering good returns with minimal risk exposure.

Structured Products, also known as structured notes, are an ideal fit in this scenario. They aim to achieve unique investment objectives that cannot be met by using traditional investments.  

Structured Products - Perfect Fit

They are instruments typically used by High and Ultra High Net-worth Individuals to diversify their portfolio into assets that limit the outcomes of an investment to a defined few.

Until recently these products were only available through private banks. Thanks to a vast improvement in Fintech, they are now also available for retail investors as well.

What is a Structured Product?

Steel is an alloy of iron and carbon; both of these elements have distinct properties. But when we put them together we get a non-rusting and versatile alloy which is infinitely recyclable.

Similarly, structured products offer a unique risk-reward trade-off when two or more financial instruments are combined.

Structured Products - Risk Reward Trade-off

A Structured Product is a tailor-made/ pre-packaged investment with a specific maturity date and a defined objective. 

Common objectives of a Structured product is either to provide a regular income or an addition to the capital on maturity with full or partial capital protection.

They typically use traditional assets like stocks or bonds or indices with a derivative to achieve the desired objective on maturity after a certain number of years.

Who issues the Structured Note?

A structured note is typically issued by large International Private banks like Credit Suisse, Morgan Stanley, BNP Paribas, DBS, BBVA, JP Morgan etc. 

It has pre-defined features like Maturity Date, Coupon Date, Level of Capital Protection and other terms.

Until recently they were only available to Private banking clients & Institutional Investors, but now they are also available on retail platforms.

How do Structured Products work?

Structured Notes usually offer full or partial capital protection. They are ideal for investors, who want to profit from a particular view of the market, but at the same time want to protect their capital. 

Repayment at Maturity

Structured Products - Perfect Fit (1)

These notes pay back the capital along with the returns on maturity.  The returns depend on the performance of the underlying assets – like indices, stocks or commodities. Such notes are ideal for people looking to invest for a certain goal due in the future.

Notes with 100% capital protection offer relatively lower returns. You can increase the returns by decreasing the level of capital protection.

Typically structured notes with a basket of indices are less riskier than notes with momentum stocks(Tesla, Nvidia, Facebook, etc...) as underlying assets.

For example:  a note with 100% capital protection may offer 25% returns on maturity in 5 years. If you are willing to take a certain amount of risk, you may opt for a note with 80% capital protection offering 35% returns in 5 years.

Income Providing Notes

You can also invest in notes providing a regular income/coupon subject to the performance of the underlying asset. 

As long as the underlying asset value is above a pre-defined value, the Note will pay a fixed income at agreed intervals.  

Structured Products for Passive Income

If the underlying asset value goes below the pre-defined level, then there is no coupon paid for that period. Some notes come with a memory feature, which will pay the missed coupons when the value of the underlying goes above the pre-defined level.

So it is important to choose stable underlying assets.Typically structured notes with a basket of indices are less riskier than notes with momentum stocks(Tesla, Nvidia, Facebook, etc...) as underlying assets.

Pros and Cons of Structured Products

Advantages

1. Defined returns

Unlike the underlying assets, structured products offer a pre-defined return outcome. 

2. Capital protection barriers- 

Structured Notes typically offer capital protection, irrespective of market movements.

3. Pre defined maturity dates

All notes come with a pre-defined maturity date, so it is easy to align the investment to a particular goal.

4. Easy to understand Outcomes 

While it is difficult to estimate the outcome of a stock or an index investment over a 5-6 year period, it is relatively easy to estimate the outcomes of a Structured Product.

Drawbacks

1. Illiquid: 

Unlike other stocks, Bonds or Mutual Funds structured products are not liquid. They come with a specific maturity period of 1 - 7 years. However, you can exit by selling in the secondary markets at the prevailing rates.

2. Credit Risk: 

The distribution of both returns and capital are subject to the Issuer not defaulting on their obligations. So it is crucial to invest only in notes issued by reputed international institutions with a strong credit rating and balance sheet.

Summary

Structured Products are investments designed to provide pre-defined outcomes with capital protection. They can give a balance to your investment portfolio. 

The above article is simplified to give a broad overview of the essential characteristics of Structured Notes.

Please review each Note carefully with your financial advisor before investing to determine if it meets your investment objectives and risk tolerance. 

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