Structured Products Explained

Explaining things that are complex

Estimated reading time: 13 minutes

Structured products are pre-packaged investments that offer returns based on the performance of one or more other securities.

Also called market-linked investments, a structured product is a strategy retail investors can implement if the underlying securities’ prohibitive cost and transaction volumes can be met.

Market-linked comes from how many structured products work.

For example, an investor believes a stock will soar in value by more than 20 per cent in a year but wants to avoid buying. So a bank issues a structured product promising to pay the total return if the stock posts a 20 per cent return by a specific date. The pledge is a market-linked note.

The investor wins a payout without directly investing in the asset if the promise is met. Most structured products come with a guarantee that protects the initial capital if the note fails to perform, making the investment almost risk-free.

What Is A Structured Product?

Structured products often replace the pay-off features of two or three securities with a new set of terms.

Most structured product features in today’s market were developed when investment banks tried to find cheaper ways for companies to borrow.

The banks added guarantees were based on convertible bonds with limits on returns wrapped in options or derivatives that increased payouts. The structured note was born when the banks prepackaged all these assets into a single product.

The structured product is a buy-only fixed-term contract between the issuer and an investor that offers enticing benefits on maturity.

Financial watchdogs regulate structured products in the USA, UK and Europe.

Structured products can be one of two types – deposit or investment products.

Most structured products do not guarantee income or growth, and while charges are deducted from returns, an investment may not perform as well as the potential looked on paper.

Each structured product is slightly different, but all have some standard features:

Fixed-term – Once investors buy into the deal, their money is locked until maturity. Most allow early withdrawal, but with hefty penalties. So investors must be prepared to tie up their money for the entire term.

Negative return protection – If the product is in the red on maturity, investors should get their money back regardless of how the product has performed.

Buy-in deadlines – Structured products have a limited time on the market – generally at most eight weeks. If investors miss the deadline, the product is closed, although a similar note is likely within a short time of the deadline.

Structured Product Risks

Structured products are complicated, high-risk investments that are difficult to value.

The main question is can investors get their money back during the fixed term?

If the product is held to maturity, the answer is usually yes, but early withdrawals are another matter. The amount returned to an investor leaving the contract early varies between providers and includes an exit fee and other charges.

Even if the structured product runs to maturity, investors cannot guarantee they will get more than their deposits back. This applies to notes linked to an index or value that falls during the fixed term.

Also, like any investment not inflation-linked, the rising cost of living will eat into any income or profits racked up by the structured product. High inflation during the fixed term could mean the initial deposit is worth less on maturity than at the start of the term.

Other risks include a lack of liquidity until the structured product reaches maturity. In addition, the complex nature of the deal makes pricing difficult during the term, which means selling a structured product to another investor is almost impossible.

Another point to watch is the creditworthiness of the issuer. High investment-grade global financial institutions issue the most structured products. Financial firms with a lower credit rating market many amid fears they may not honour the contracts if the business should fail.

How Structured Products Work

A bank with a high credit grade issues a structured note with a $1,000 notional value. Each note doubles up as a zero coupon bond and a call option on a popular stock or exchange-traded fund (ETF) tracking a stock market index. The fixed term is five years.

Investors pay their $1,000 deposit to lock into the note on the issue date. The zero coupon bond protects the deposit.

Because of the protection, the investor gets the full deposit back on maturity regardless of how the ETF has performed.

The hope is that the note will have an intrinsic value on maturity if the value is higher than the issue date.

If it is, the investor is rewarded with a payout. If not, the full deposit is still returned.

Who Can Invest In Structured Products?

Individual investors – called retail investors in the financial world – are free to buy structured products in the same way as trading stocks, bonds or other assets.

Many structured products with fixed terms of up to five years are bought as alternatives to savings accounts.

Savers take the view that their money is tied up for the same time whether they opt for structured products or fixed-term savings accounts, so the decision comes down to the likely returns.

Different Types Of Structured Products

Structured investment products, or SIPs, are packaged investments that can be favourable, with stable returns, potential capital protection and less volatility when stock markets shift sideways rather than upward.

While returns depend on market conditions and the performance of the underlying asset or assets, the ability to produce profitable returns even in adverse climates makes a SIP a useful option for investors or advisers looking to diversify or offset higher risks.

There are three categories of SIP, each with a different risk profile – structured deposits act more as a savings vehicle, like a high-yield savings account. Structured products with capital protection have lower returns but greater assurances and capital-at-risk structured products operate more like a conventional stock market investment.

Structured Deposits

A structured deposit differs from a structured investment product because it represents a fixed-term savings account, where investors earn a static return. However, the contrast is that the exact return can depend on the underlying asset.

Structured products can be linked to equities, indices, commodities, and currencies, as a few examples, so the return can alter if the asset, or basket of assets, doesn’t perform as expected.

For example, a structured deposit might offer a 20 per cent return after three years, but only provided the index it is linked to is either equal to or higher than the current levels.

It is also important to stress that no investment, regardless of its nature, is completely free of risk exposure. The inherent investment ecosystem means that any investment holds some risk, and variables can fluctuate and impact the result or predetermine whether the investment will be profitable.

The positive feature of a structured deposit account within the UK is that the product package will normally include capital protection. Suppose a structured deposit is linked to a bond, and the issuer becomes insolvent or defaults. In that case, the investor does not stand to lose their originally invested capital, even if the expected return is not forthcoming.

Accounts are protected by the Financial Services Compensation Scheme (FSCS), which safeguards deposits up to £85,000 per account holder per financial institution and will allow the investor to recoup funds if an issuing body fails.

It is essential to be conscious of FSCS limitations because the deposit protection scheme does not necessarily apply to every scenario and to every account. If you had a savings account, structured deposit, and fixed-rate bond with three banks, yet all licensed by the same financial institution, your protection would be limited to £85,000 regardless of the product balance.

Pros and cons of structured deposits

The advantage of a structured deposit is that investors can still engage with the market. At the same time, interest rates are relatively low, and stock market performance is volatile. They can achieve stable returns based on their confidence that the market will return a profit – with the added assurance of capital protection.

If the market is on par or above, most fixed-rate structured deposits will be profitable, even if the stock market performs only nominally better than at the start date.

The downside is that if markets fall and do not recover before the maturity date, the capital investment does not produce any return, meaning it may have been better invested in a straightforward savings account.

Structured Products With Capital Protection

SIPs with an element of capital protection packaged into the product act as a middle ground. They assure investors that their initial investment capital will be returned as a baseline minimum when the product reaches maturity.

They differ from capital-at-risk SIPs because they are structured comparably to a financial loan. The capital return guarantee also depends on the issuing body, which is normally a bank or established financial institution. Investors should assess this factor before assuming all capital-protected SIPs are equal.

Provided the issuer is solvent, the SIP will deliver a return. Still, if a counterparty becomes insolvent, enters administration, or declares bankruptcy, there is the potential to lose the entirety of the investment.

Because these products are classified as investments rather than savings products, they do not have the same protection afforded by the FSCS – although the returns are equally likely to be higher, reflecting the increased risk the investor accepts.

Capital-At-Risk Structured Products

The final category is a structured product with capital-at-risk, the market’s most common product investors will find. Returns are higher than either alternative but are balanced by the possibility of losing all capital invested if market performance moves downward.

Essentially, the proposed return is the premium the investor accepts for absorbing increased risk, although many SIP product packages will protect the capital balance unless the markets perform very poorly.

For example, a SIP linked to the FTSE 100 might not be on par if the market drops but might return less than the initial capital invested if the market falls by 50 per cent or more. This scenario is unlikely but possible.

The extent of capital protection and likely returns is tied to the underlying asset and the security included within the packaged investment. However, the key is to recognise that, unlike structured deposits or capital-protected SIPs, a capital-at-risk SIP can potentially make a loss.

Any return rates advertised for a packaged SIP with capital at risk depend on the bank or issuing party being solvent and upholding any agreements to safeguard capital outside FSCS protection.

Understanding Variances Between Different Types Of SIP

SIPs are a popular alternative to high-yield savings accounts or fixed-rate bonds when markets are generally sluggish or underperforming. Still, investors need to grasp the differential between alternatively structured product categories.

There are different product types, as discussed. However, these further devolve into categories, split as follows:

  • Auto call SIPs are investment products that can mature before expiry if market conditions support this.
  • Kick-out SIPs mature before the expected date if the underlying asset meets or surpasses a percentage of the original strike level or a defined valuation.
  • Reverse convertible SIPs act as income products that pay a return higher than the average interest rates available from mainstream savings accounts and inflation, with interest remitted monthly, quarterly, six-monthly, or annually. The product involves at-risk capital, with the return calculated based on underlying asset performance.

Some SIPs are sold as fixed-term products, but the payout can vary. Fixed returns are solidified if the selected asset meets performance objectives, tested at predetermined dates. If those objectives are not met, the investor only receives their initial capital.

There is also a risk that capital will drop by whatever percentage the underlying asset underperforms or falls below the original level when the investor first purchased the product.

As a takeaway, SIPs can be a convenient investment product with beneficial flat-rate returns over and above those available elsewhere. The caveat is that growth is capped, and if the underlying asset or index does not perform as expected, investors may receive only the returned capital – or, in the worst-case scenario, less.

Why does capital protection depend on the category of SIP?

SIPs are structured packages and financial products, and they can provide protection in several ways:

  • Continuous protection means the issuer monitors the underlying asset during every trading period and depreciates the capital at the end of the term if the supporting asset or index remains below parity.
  • Daily close protection references the asset at the end of each trading period. The capital is lost if the asset is beneath the threshold and remains so at maturity.
  • Maturity protection ignores the asset value until the term ends and assesses the current market price only at that point.
  • Leveraged put protection means capital is lost at any point in a linear time scale once the asset falls past a threshold.

Structured Products FAQ

What is a rainbow note?

One of the main benefits structured products offers investors is the ability to wrap several assumptions into a single package. Issuers call this a rainbow note because they give exposure to more than one asset.

What is a lookback note?

A lookback note calculates a full-term value from averaging prices during the structured product’s fixed term. These milestones could be monthly or quarterly.

What is a derivative?

A derivative is a financial contract with a value based on underlying assets. The contracts can be traded on exchanges or over the counter. Common derivatives are options, swaps and futures.

What is a market-linked investment?

Market-linked investment is another name for a structured product which derives a value from underlying assets, like a market index, stocks and shares, currencies, interest rates or commodities.

What’s a retail investor?

A retail investor is a non-professional or individual investor who buys and sells stocks, shares, funds or other securities, typically through a broker or online platform.

What’s a convertible bond?

A convertible bond is a fixed-income corporate security that pays interest but can also convert the bond value into stocks or other equity.

Why are structured products risky investments?

Trade body the UK Structured Product Association (UKSPA) identifies five risks investors should consider before taking up a structured product offer:
Counterparty – Who holds the deposit, and what recourse do investors have if the deposit holder goes bust?
Length – How long is the fixed term, and can you afford to do without the deposit for that time?
Exposure – What underlying assets is the deposit linked with?
Access – How do you withdraw the deposit early, and what are the exit penalties?
Returns – What is the minimum you can expect to make at maturity?

How should investors choose the right SIP?

As with any investment, the best approach is to revisit your objectives and decide whether a structured product complies with your aspirations and goals. Investors also need to evaluate investment costs, potential returns, risk appetite and whether they can stand to lose the capital invested.

Is a long-term SIP high-risk?

Much depends on the reputation, stability, and status of the issuer. Most SIPs are issued by established banks or financial institutions, where the risk of default or insolvency is low, and the potential to lose capital is minimal.

SIPs are generally considered a safe investment, depending on the capital protection provided.

Why are some types of SIPs FSCS protected, and others aren’t?

The FSCS protects consumer deposits but isn’t an unlimited insurance scheme. Invested funds and those paid into an investment, cash, or currency account outside a credit union, bank or building society fall outside the FSCS remit.

What is a structured investment product?

Structured investment products, abbreviated to SIPs, are a form of alternative investment. They can be straightforward or complex. They are normally either listed on exchanges or sold directly, packaged with deposit protection, fixed or variable returns, and potential outcomes linked to the underlying asset or asset pool.

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