What is a Structured Product ?

Structured product investments provide investors with the opportunity to invest in stockmarkets and other asset classes within pre-defined risk and returns parameters. Since the early 1990’s, structured investments have evolved rapidly worldwide and are now regarded as mainstream investment solutions by many investors. In the UK, in 2010, nearly 100 providers issued approximately 1000 products, which were collectively responsible for retail sales of over £10billion. Throughout the EU in 2012 €109.3 billion were sold to the retail investor market. Sales volume of this magnitude reflects the diversity of offerings – and demonstrates the wide appeal and flexibility of structured product investments to add value to investor’s portfolios.

Investing with the benefit of a defined risk and returns potential clearly empathises with the interests of many investors. This is especially evident during periods of stockmarket uncertainty or volatility such as we have been passing through over recent years. A structured product investment can quantify and specifically state the levels and types of investment risk that may apply to an investor’s capital and/or the investment returns -providing innovative and compelling investment solutions, as alternatives or compliments to traditional investment funds.

As with any type of investment, structured products do not come gift wrapped without any risks. A key risk that applies to any structured product is the strength of the issuer of the product or note – otherwise known as the counterparty.  The counterparty of the structured product is therefore responsible for the payment of any income that may be due during the term and for the repayment of capital (and any growth) at maturity. If the counterparty were to default investors could lose some or all of their capital so clearly one needs to proceed with caution when selecting the underlying counterparty for any structured product.

Structured products can be split into three main groups, these being:

1. Structured Deposits – Basically a fixed term deposit account that instead of paying a quoted rate of interest, the return payable will be linked to one or more variables – such as the FTSE100. For example the counterparty may provide 100% return of capital plus a return of 20% after 3 years if the FTSE100 is at the same level or higher as when the plan started. As it is a structured deposit, protection is usually provided for by the UK Financial Services Compensation Scheme up to £85,000 per individual per institution in such circumstances. Although this might not be the case where the investment is made via a life company or other type of wrapper product so care should be taken to understand the risks beforehand.
2. Structured Capital ‘Protected’ Products – These are similar to structured deposits, however they are often structured as loans to a bank or other types of financial institution. In this case they won’t be protected by the FSCS and in the event the counterparty becomes bankrupt investors may lose some or all of their capital.
3. Structured Capital at Risk Products – This is by far the most common category and also the one that offers the highest returns on investment if the objectives are met. With theses types of products in addition to the counterparty risk, further capital protection will be dependent upon a protection barrier not being breached. For example the structured product may pay a return of 10% per annum as long as the FTSE100 stays above 80% of its starting level (as recorded on the product start date -known as the strike date), with capital returned at full at maturity (in 5 years) providing the FTSE100 does not close at lower than 50% of its opening value. Basically this provides for falls of up to 50% in the FTSE100 before capital is at risk. Usually if this threshold condition is broken , then falls in excess of 50% will also result in capital being reduced on a 1 for 1 basis. Some products have a European barrier which means the barrier or threshold condition is measured only at maturity whilst the more risky American barrier takes into account falls of 50% or greater measured on any day throughout the term.

The securities that Counterparties issue are usually Medium Term Notes, Warrants, or other securities, which are similar to a corporate bond and other types of debt instrument – often referred to generally as ‘bonds‘. In effect, an investment in a structured product is a loan to the Counterparty, in exchange for the returns of the Plan. These are specifically structured to match the investment objectives (ie features) and fixed maturity of the Plan (typically 1, 3 or 5 years.  The Counterparty must meet the contractual terms of the bonds that they have issued – and their ability to do so largely depends upon their solvency. The risk that they might fail to meet the terms of their bonds is known as ‘Counterparty risk’ , as discussed above, and sometimes also referred to as ‘credit risk’.

A Counterparty failure during the investment term of a structured investment Plan, for instance through insolvency, such as bankruptcy, administration or liquidation, is likely to cause a ‘default’, ie the Counterparty will fail to make payments due during the investment term and/or to repay their debts, ie the bonds, at maturity. Usually the risk of a major financial institution failing to be able to meet its commitments in this way can be considered small – but a default or failure puts a structured investment, and any growth or income potential it provides, at risk – so the risk must be understood by investors as with any other risks that apply to more traditional based investments.

In addition to considering the investment capability and service of different banks/institutions, assessing the financial strength of prospective Counterparties is an important aspect of any structured products provider. The accepted method of assessing the financial strength of an institution is measuring their ‘creditworthiness’.

Credit ratings are assigned by independent organisations known as Credit Rating Agencies (CRAs), and the three leading CRAs are Standard and Poor’s, Moody’s and Fitch Ratings. Ratings are normally in the form of letter designations, such as AAA, A+, BB, C, etc. A rating of BBB or higher is considered as investment grade and anything below, sub investment grade (probably the type you might want to avoid!) while at the other end of the spectrum the highest award is AAA; which according to the rating agency Standard and Poor´s is defined as ‘the capacity to meet financial commitments is extremely strong (the world´s major companies and governments) These ratings provide investors in the debt securities of these institutions, such as a bond, with an indication of the institution’s strength and ability to meet its obligations in repaying both the principal capital and any income due from the security.

Whilst there are certainly benefits to be gained from having some exposure to good structured products investments, we would only advise investing in them after speaking to an experienced Independent Financial Adviser who can help identify with you which structured products are suitable to be held within your own portfolio, and thus also ensuring you are familiar with all the risks that they might involve. Please fill out our quick contact form to speak to an expert or to request your own free report.