Structured products or Euro Medium Term Note (EMTN) – Structured products are combinations of two or more financial instruments, forming together a new investment product. At least one of them must be a derivative product.
Structured products with capital protection are the most frequently traded. Such products can be traded either on the stock-exchange or over-the-counter.
Due to the important number of possible combinations, each structured product has its own risks since the risks associated to each of the elements of this combination can be reduced or even eliminated or enhanced due to such a combination. Consequently, the investor must inquire about the specific risks associated to the relevant structured product. Such information is available, for instance, in the commercial brochures or form sheets describing the product.
1.1. Characteristics: Structured products or Euro Medium Term Note
- Two elements: such products consist generally of two elements: a fixed-income investment (e.g. bond or money market investment) and an option or combination of options. This enables the investor to participate in the price movements of one or more underlying assets while at the same time limiting potential losses. The capital protection component may, if applicable, only cover a portion of the capital invested. Moreover, the participation and protection elements can be separated into two separate components in order to ensure the independence of the two components or even to permit to sell them separately; Structured products or Euro Medium Term Note
- Capital: fully or partially secured (upon maturity). The capital protection component determines how much of the nominal value of the structured product will be paid out to the investor, irrespective of any price movements in the option component; Structured products or Euro Medium Term Note
- Yield: the option component or direct investment in a risky underlying asset determines how and to what extent the investor can benefit from price movements in the underlying. Therefore, this component determines the potential return over and above the capital protection component; Structured products or Euro Medium Term Note
- Flexibility: these products can be tailored to suit the needs of each client and are adaptable to all types of underlyings.
1.2. Advantages: Structured products or Euro Medium Term Note
Such products enable the investor to invest on a market while reducing the risk of losing capital which would exist if he invested directly on the same market. Returns may be higher than those of monetary or bond investments with an equivalent level of protection.
1.3. Risks: Structured products or Euro Medium Term Note
1.3.1. Risks at the level of the capital protection component
The capital protection is linked to the nominal value of the product rather than its issue price or purchase price on a secondary market. Therefore, the investor benefits from a guarantee only up to the nominal value of the product with the consequence that capital protection does not necessarily mean 100% repayment of the capital invested.
Consequently, the protection will be reduced if the issue/purchase price is higher than the nominal value and, conversely, increases if the issue/purchase price is lower than the nominal value, in particular, if the product has been purchased at a price which was different from par or after the original issue. The level of protection depends on the creditworthiness of the issuer. The capital is therefore protected only if the issuer of the protection can meet his obligations. Structured products or Euro Medium Term Note
The maximum loss is thus limited to the difference between the purchase price and the amount of the capital protection upon maturity. However, over the life of the product, its price can fall below the level of the capital protection amount, which increases the risk of loss in case of sale prior to expiration. Capital protection is only guaranteed for the investor if the latter holds on the product until maturity but is not ensured if early repayment is requested. Structured products or Euro Medium Term Note
Upon maturity, if the capital is not guaranteed up to 100%, the investor will not be repaid the full amount originally invested.
1.3.2. Risks at the level of the option/direct investment component
Depending on the evolution of prices in financial markets, this component can expire without value. The risks associated to this component are the same as the risks associated to the relevant option or option combination or direct investment used. Structured products or Euro Medium Term Note
Due to the existence of a capital protection, the investor may obtain a lower return than the return he would have obtained if he had invested directly in the underlying.
1.3.3. Liquidity risk
The liquidity of the investment is usually ensured only above a certain amount, subject most of the times to a bid/offer spread and/or a penalty in case the product is not held on until maturity.
2. Structured products without capital protection: convertible reverse or discount certificate
2.1. Characteristics: Structured products or Euro Medium Term Note
- Term product: the investor receives a guaranteed coupon in a given currency but accepts a risk on his capital on maturity;
- Underlying assets: shares, indexes, baskets, etc…;
- Capital: protected if the market value of the underlying is not lower than the strike price on maturity;
- Repayment: in cash or by delivery of the underlying, at a strike price determined in advance, if this strike price has fallen or been exceeded. On the maturity date, if the price of the underlying asset is higher than the strike price, the investor receives the guaranteed coupon plus 100% of the capital initially invested (in cash). If the price of the underlying asset is lower than the strike price, the investor receives the guaranteed coupon plus the underlying asset at the strike price;
- Flexibility: such products can be adapted to all types of underlyings;
- Discount certificate: in this case, the investor receives the coupon only upon maturity but originally purchases this product at a discount.
2.2. Advantages: Structured products or Euro Medium Term Note
Incomes are higher than for investments in money market products. They are short term investments and thus it is easier to assess potential earnings.
2.3.1. Risks at the level of the capital Structured products or Euro Medium Term Note
The capital protection is not guaranteed if the investor receives the underlying asset instead of the capital invested upon maturity. The capital risk is closely linked to the evolution of the price of the underlying asset.
2.3.2. Liquidity risk Structured products or Euro Medium Term Note
The liquidity of the investment is usually ensured only above a certain amount. Structured products or Euro Medium Term Note
2.3.3. Exchange rate risk
For the products denominated in currencies other than that of the underlying asset, the investor is exposed to an additional exchange risk.
3. Credit-linked notes (‘CLN’)
An investment in a CLN can be compared to a direct investment in a floating rate note issued by the same entity.
3.2. Risks: Structured products or Euro Medium Term Note
3.2.1. Dual risk
An investor in a CLN bears the credit risk of both the issuer of the CLN itself and of the underlying credit reference entity/ies. In case of a credit event, the investor receives either a debt instrument (i.e. a bond or a loan) issued or guaranteed by the relevant credit reference entity or a cash settlement amount linked to the market price of such debt instrument, calculated on the basis of the relevant credit event.
3.2.2. Risk enhanced by the scope of the notion of “credit event” Structured products or Euro Medium Term Note
The term credit event is defined in broad terms and encompasses more than simply a bond default of the relevant reference entity. Indeed, this concept encompasses, for example, an extension of the repayment date of a loan or a decrease in the rate of interest payable on such loan. Therefore, the holder of a CLN can suffer a loss due to a credit event even though a traditional bond default did not occur. In other words, the probability that a credit event occurs is higher than the probability that a bond default occurs.
3.2.3. Scope of the risk of loss Structured products or Euro Medium Term Note
A credit event might result in a CLN suffering a greater loss than the average loss suffered by bonds from that same reference entity since the issuer of the CLN generally has a wider choice of the debt instruments to be delivered on a default and could choose to deliver the lowest priced debt instrument. This risk is mitigated in some structures through pre-defined recovery rates, which determine in advance, for instance, the loss in case of a credit event.
Moreover, a higher loss may occur as a result of a delivery of a bond or loan with a duration longer than the duration of the CLN itself or in case of a valuation using such a bond/loan. However, major rating agencies are aware of these two characteristics and incorporate them into their ratings of CLNs. Structured products or Euro Medium Term Note
4. Collateralised debt obligations (‘CDO’)
4.1. Characteristics: Structured products or Euro Medium Term Note
Collateralised debt obligations are also structured products based on an underlying basket or portfolio of debt instruments, which can be bonds, loans and/or credit default swaps.
A CDO is usually divided into several tranches providing different levels of risk exposure for the basket of underlying debt instruments. Commonly, the most junior tranche is an “own funds” tranche and the tranches then go up in increasing seniority and correspondingly higher credit ratings.
Through these synthetic structures, the investor gains exposure to underlying credits which are not always available through direct bond investments.
4.3. Risks: Structured products or Euro Medium Term Note
4.3.1. Risks related to the system of tranches
Losses on the portfolio are borne firstly by the holders of the “own funds” tranche and subsequently by the holders of the various tranches in order of seniority. The holders of a senior tranche only incur a loss due to a relevant credit event if all the own funds and the capital of the more junior tranches have been lost. Therefore, tranches which are not “own funds” tranches have some degree of protection against losses whereas the “own funds” tranche and the more junior tranches represent a leveraged exposure to the fluctuations of the underlying portfolio.
Credit events on a small portion of the underlying portfolio can lead to significant or total loss of the capital invested in the “own funds” tranche and the more junior tranches.
4.3.2. Risks related to the long-term nature of the product Structured products or Euro Medium Term Note
The value of any credit derivative can vary significantly before maturity depending on factors including, for instance, the occurrence of credit events and movements of credit spreads in the portfolio.
Moreover, like any debt instrument, the initial rating of any credit derivative can be upgraded or downgraded. A credit rating of a particular instrument reflects the (long-term) default risk of that instrument until it matures, and not short-term market risk. Investors in a credit derivative should generally have a long-term investment perspective and the ability to hold the product until maturity.
4.3.3. Risk related to the low liquidity Structured products or Euro Medium Term Note
Such instruments are generally illiquid even though a secondary market may exist.