Investors often find themselves at the edge of their comfort zone when faced with the complexity of structured products. These sophisticated financial instruments, shrouded in intricate jargon and perceived risks, can be confusing for even the most seasoned investors. Yet, the unfamiliarity with complicated products often overshadows the potential benefits that structured products can bring to a well-diversified investment strategy if utilized wisely and properly.

This article is crafted to demystify structured products, breaking down their components and illustrating how they can be powerful tools to meet specific financial goals. Whether you're a high-net-worth individual or an institutional investor, understanding the mechanics and potential of structured products can empower you to make informed decisions, alleviating the uncertainty that often accompany these investments. Join us as we delve into the world of structured products and help you navigate and incorporate these instruments into your portfolio.

Summary

• ‍Expansive Growth: The structured products market, originating in the 1990s, has ballooned to trillions globally, driven by evolving financial engineering and persistent demand for higher returns in varying interest rate environments.‍
• Innovative Strategies: Modern structured products embed options to amplify upside potential, guarantee minimum returns, or offer stable fixed income, thus tailoring to diverse investment objectives.‍
• Pros and Cons: While structured products offer bespoke solutions and innovative strategies, they face challenges like liquidity constraints and fixed time frames, demanding careful consideration by investors.

Size and History

The structured products market has seen remarkable growth over the past few decades, now accounting for trillions of dollars globally. The origins of structured products can be traced back to the early 1990s when they were first developed to offer enhanced returns in a low-interest-rate environment. Initially, these instruments were relatively simple, often consisting of basic debt securities combined with derivative components. Overtime, the market has evolved significantly, and structured products now encompass a wide array of complex financial instruments designed to provide tailored solutions for various market conditions and investment strategies.

Growth and Development

The expansion of the structured products market can be attributed to several factors. First, the prolonged period of low interest rates 30 years ago has driven investors to seek alternative avenues for higher returns. Second, in today’s high interest rate environment with the US Effective Federal Funds Rate (EFFR) being at 5.33% and the actively traded yet volatile US equity market with funds concentrating in the AI sector, investors are seeking more customized and adaptive investment products to preserve their wealth and boost their return furthermore. Structured products, with their ability to offer enhanced yields and flexibility to incorporate versatile strategies, have become increasingly attractive in this ever-changing economy. Additionally, advancements in financial engineering and technology have enabled structurers’ creation of more sophisticated products, further expanding the market.

Nature Explanation

Option Embedded Strategies

So, what are the structures in the structured product? Structured products often incorporate options and other derivatives to achieve specific investment objectives. Below, we will explore three common strategies: amplifying upside potential, minimum redemption guarantees, and stable fixed income.

1. Amplifying Upside

Structured products can be designed to amplify the upside potential of an investment by embedding call options. This strategy allows investors to participate in market gains while limiting downside risk.

Consider a 3-month-tenor structured product – Bonus Enhancement Note (BEN) – linked to the performance of a US equity, such as NVDA. Certain structures can make the payoff of the product attractive to clients than directly investing in the stock. The BEN might offer an annualized bonus coupon of 10%, set up a strike price of 85% of the initial price of the underlying stock. There are three possible scenarios at the maturity date:

• If the underlying stock price rises sharply, the maturity price/initial price ≥ strike price, and the maturity price/initial price – 1 ≥ the 10% bonus coupon, the investor can get payoff of 100% + maturity price/initial  price – 1
• If the underlying stock price rises slightly, the maturity price/initial price ≥ strike price, and the maturity price/initial price – 1 ≤ the 10% bonus coupon, the investor can get payoff of 100% + 10% bonus coupon
• If the underlying stock price falls below the strike price (the maturity price/initial price < strike price), investors must buy the underlying stock at the strike price, which is equivalent to buying low. However, if the stock price cannot rise over the strike price, investors may lose the difference between the strike price and the maturity price, posing potential risks.

The detailed features of a structured product will be explained in the Termsheet – a contractual agreement between the bi-party (the buyer and issuer of the product).

2. Minimum Redemption

Structured products with minimum redemption guarantees provide a safety net for investors. These instruments ensure that, regardless of market performance, the investor will receive a minimum return at maturity. This is achieved by embedding a buy call option, which protects against significant losses.

Principal Protected Note (PPN) Booster - discussed in our previous article - is an example structured product that guarantees a minimum redemption of a portion of the initial investment, regardless of the performance of the underlying asset while allowing participation of its upside potential. For example, if the underlying asset performs poorly and loses 20% of its value, the investors would still receive 95% of their initial investment at maturity, thereby limiting their loss to 5%. On the other hand, if the asset performs well by +30%, given a 40% participation rate, the investors can still benefit from the 12% upside by maturity (30% × 40%). However, PPN Booster also has certain limitations, such as only able to participate in a portion of the gains in an upward market due to its 40% participation rate, thus unable to fully enjoy the market upside even when the underlying asset is performing well.

3. Stable Fixed Income

Structured products can also offer stable fixed-income returns by providing flat coupon. Consider a 3-month-tenor structured product –  Fixed Coupon Note (FCN) – linked to the performance of a US equity, such as AAPL. An FCN is composed of a Zero Coupon Bond (ZCB) and a sell put option. The flat coupon it provides comes from the end coupon of the ZCB and the premium from the sell put option. Suppose the FCN might offer an annualized flat coupon of 12%, set a strike price of 90% of the initial price of the underlying stock, and be observed at every month-end. There are two possible scenarios at the maturity date:

• If the underlying stock price is above the strike price (90%) at the observation day, investors can continue holding the FCN until maturity and receive 12% annualized flat coupon.
• If the underlying stock price falls below the strike price (90%) at the final valuation day, investors must buy the underlying stock at the strike price at the maturity date and receive the 12% annualized coupon. Investors may lose the difference between the strike price and the maturity price and minus the coupon received.

Therefore, if investors consider the price of the underlying stock to be relatively stable, less likely to fall below the strike price (90%) at the final valuation day, they can buy this FCN and hold until maturity to enjoy fixed income return. However, if the price of the underlying stock is relatively volatile, more likely to fall below the strike price at the final valuation day, investors may lose their investment. Therefore, investors need to think carefully about the features setup of the FCN when considering buying in.

Pros & Cons

Pros

1. Bespoke Solutions

As structured products are all Over-the-Counter (OTC) products, meaning that they are highly customizable, allowing investors to tailor their investments to specific financial goals and risk profiles in a dynamic market given their current holdings. Clients can choose the optimal to trade from quotes offered by various issuers. Their consideration may include coupon rate, strike price, knock-in (KI) barrier, knock-out (KO) barrier, credit risk of the issuer, etc. This flexibility makes them suitable for a wide range of investment strategies.

An investor seeking exposure to emerging markets with capital protection can choose a structured product that offers participation in an emerging market index while ensuring that the initial investment is protected at maturity. This bespoke solution provides the desired exposure with a safety net.

2. Flexible Features

Investors can achieve various features within a single product, such as capital protection, enhanced returns, and income generation. This versatility makes structured products an attractive addition to diversified investment portfolios.

A structured product might offer both regular coupon payments and potential equity upside. An investor looking for income generation and growth potential can benefit from this dual feature, balancing their portfolio with stable income and the possibility of higher returns.

3. Innovative Strategies

By embedding options and other derivatives, structured products can offer unique investment opportunities that are not available through traditional financial instruments. This innovation can lead to enhanced returns and better risk management.

For example, a product that provides leveraged exposure to a basket of commodities while capping potential losses offers a novel way to gain from commodity price movements. However, traditional investments in commodities may not provide the same level of risk management and return enhancement.

Cons

1. Illiquidity

One of the primary drawbacks of structured products is their lack of liquidity. Being OTC products whose features are all tailor-made, these instruments are often not traded on secondary markets, making it difficult for investors to exit their positions before maturity. This illiquidity can be a significant disadvantage, particularly in volatile market conditions.

For example, an investor holding a structured product linked to the performance of a tech stock may find it challenging to sell the product before maturity if market conditions change or personal circumstances require liquidity. The lack of a secondary market limits flexibility.

2. Time Frame Constrained

Structured products typically have fixed maturity dates, which can limit their flexibility. Investors must be prepared to hold these instruments until maturity to realize their full benefits. This time constraint can be challenging for those with shorter investment horizons or changing financial needs.

An investor who anticipates needing funds in three years might find it difficult to commit to a structured product with a five-year maturity. Any unexpected need for liquidity before the product matures could result in financial inconvenience or loss. In reality, KO barriers or Autocall features will be structured into the product to ensure faster exit as sales and traders on the sell side also want to close their position by shortening the product period to increase their turnover and manage risks.

Conclusion

Structured products offer a versatile and customizable approach to investing, making them suitable for various market conditions and investor profiles. However, potential investors must carefully consider the liquidity and time constraints associated with these instruments. By understanding these factors and leveraging the innovative features of structured products, investors can effectively incorporate them into their investment strategies, balancing risk and reward to achieve their financial objectives.