Bonus certificates

Bonus certificates are financial instruments. Bonus certificates represent patrimonial rights (wikipedia-link) as defined in the terms and conditions of issue of those bonds. Bonus certificates are participation products that feature full upside participation and a conditional capital protection as long as the underlying asset doesn’t cross a predefined threshold (barrier).

In most products, a fixed “bonus” will be paid to the holder of the certificate if the underlying asset didn’t cross the preset barrier and if the performance of the underlying asset is lower than the predefined bonus.

Hence, bonus certificates tend to perform well in both sideways and rising markets. There are however two major disadvantages of the product: first, bonus certificates do not pay out any dividends, which stock shareholders get on a yearly or quarterly basis. Second, the payoff shown below is only valid at maturity; the mark-to-market price of the bonus certificate during its lifetime differs strongly from its final payoff. It may be stated that in general, the contingent protection and bonus will only “grip” after most of the product’s maturity has elapsed.

Characteristics

In general, they come in the form of par value debt instruments that entitle their holder to a part of the profit of the company.

As a matter of principle, fixed or variable distribution bonus certificates must be distinguished from bonus certificates with option or conversion right.

Risks

Absence of distribution or reduction of repayment

In case of losses by the issuing company, interest payments may be halted if no minimum interest payment has been provided for. In addition, the repayment of the principal amount may be reduced.

Issuer risk

The bankruptcy of the issuer entails the complete loss of the invested funds.

Bonus certificates combine three advantages in one product. The investor benefits from rising prices of the underlying instrument, receives a sizeable bonus payment, and, in the case of falling prices, is protected up to (or in fact, down to) the safety barrier. In case of an unexpected slump, the bonus payment is dropped, and the price of the underlying instrument is credited at the end of maturity.

Example of  a bonus certificate

Bonus certificates

Remaining term to maturity: 2 years
Underlying: CS Group N
Bonus level: CHF 33.00
Safety threshold: CHF 24.00
Current price of certificate: CHF 30.00
Current price of stock: CHF 30.00

Bonus certificates Bonus certificates

If during the term of the certificate the shares of Credit Suisse never trade at or below the safety threshold of CHF 24, upon maturity you’ll receive payment of at least the bonus amount of CHF 33, regardless of where the share price stands at that point. That equates to a total return of roughly 10% on the original amount invested. But the return can be even more generous if the stock actually trades higher than the bonus level. In such an instance, you’d participate fully in the additional price increase.

If, however, the safety threshold of CHF 24 is breached during the term to maturity, the bonus mechanism terminates, in which case you’ll receive the current market value of the stock when the certificate matures. If the share price is below the price you originally paid for the certificate (i.e. CHF 30), you’ll suffer a loss.

Do’s

  • Do invest in bonus certificates when the volatility is high, or expected to fall.
  • Do invest in bonus certificates when the skew is high or expected to fall.
  • Do invest in bonus certificates when the dividend yield of the underlying stock or index is high or expected to fall.
  • Do favor a better contingent protection over a higher bonus.
  • Do favor a shorter time to maturity over a higher bonus level or a better contingent protection.
  • Evaluate the benefits versus the costs of a European style down&out barrier. Usually, bonus certificates have an American Style barrier that can be knocked out anytime, even intraday. It may be worthwhile to choose a European style barrier, which can only be knocked-out at maturity. Or try a window barrier, which can be knocked out only during a certain time window within the lifetime of the product, say the last 3 months, which may be of advantage if the cost is not too high.
  • In some jurisdictions, it is possible to optimize your after-tax returns with Bonus Certificates.

Don’ts

  • Don’t invest in bonus certificates with a remaining maturity of more than three years.
  • Don’t raise the bonus level to the detriment of the barrier. If the barrier is breached, the bonus will disappear along with it.
  • Don’t use the bonus certificate for frequent in and out trading.
  • In worst-of bonus certificates, don’t use more than 2, eventually 3 underlying assets.

Classical variants

  • Capped bonus certificates: the cap is usually placed at the level of the bonus; the structure then resembles a barrier reverse convertible with a non-guaranteed coupon.
  • Worst-of bonus certificates: the product has several underlying assets, and any one breaching the barrier knocks-out the protection along with the bonus. The imperfect correlation of the two assets can be used to lower the barrier or raise the level of the bonus; it can also be used to increase the level of the participation.
  • Clicket bonus certificate: once the underlying asset has reached a certain price level, the bonus certificate transforms itself in a capital guaranteed product, with an unconditional capital guarantee.

Historical perspective

Bonus certificates

During the bull market years of 2003 through 2006, many investors in discount certificates were annoyed that, because of the predetermined cap, their returns lagged those to be had in the general market. At the same time, though, they didn’t want to make do without a certain safety buffer against price declines.

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The solution to that problem was the bonus certificate.

At the time they’re issued, bonus certificates normally have a term to maturity of two to four years. They guarantee that you’ll receive a specified payout (“bonus level”) as long as the underlying instrument doesn’t touch or fall below an established price level (“safety threshold”) during the term of the certificate.

In contrast to discount certificates, the maximum payback isn’t limited to a fixed amount: if the underlying instrument rises above the bonus level, you continue to participate in the price gains. Depending on the features of the product, you can often earn double-digit returns while assuming an acceptable degree of risk.

However, if the safety threshold is breached, then the protective mechanism of the bonus certificate vanishes in a heartbeat. In such an instance, you’ll be in the same economic situation when the certificate matures as you would have been had you invested directly in the underlying instrument. Once the breach occurs, the certificate behaves just like an index certificate.
If after a penetration of the safety threshold the price of the underlying instrument goes back up, you can still participate 1:1 in those gains; however, the right to a guaranteed payout of the bonus level no longer exists and it is not reinstated as a result of any such move.

The probability that the safety threshold will be penetrated already increases when the price of the underlying instrument starts to ease toward that level. Thus in this example, the price of the bonus certificate can retreat significantly even before the threshold is hit. By the same token, the price can rise all the more sharply when the underlying instrument gains distance again from the safety threshold without having penetrated it.

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Bonus certificates

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