Structured products are difficult to define simply or precisely. Some people consider a convertible bond to be a structured product, for example. Others say that structured products refer only to debt securities issued by banks and never by companies – which would exclude most convertible bonds.
Still, there is general consensus that a structured product refers to a debt security that is comprised of several different financial instruments. Structured products allow the seller to offer a tailored instrument with a risk profile corresponding to the buyer’s needs and expectations.
A structured product is therefore a security that combines:
- the characteristics of a fixed income instrument or a short-term deposit;
- the risk and return characteristics of a derivative contract.
Structured products differ from traditional investments because they allow for bespoke solutions that correspond to an investor’s needs. They are tools adapted to the risk profiles defined by the investor.
Structured products are offered across all asset classes. Their returns can be linked to the performance of a number of underlying benchmark, including:
- interest rates;
- stock markets;
- foreign exchange markets;
In the case of equities, the benchmark could be a stock market index (CAC 40, Eurostoxx 50, etc.) or a defined basket of shares (equity structured products). Alternatively, the benchmark might be the exchange rate of one currency against another (currency structured products) or an interest rate – or even the difference between two interest rates (interest rate structured products).
But since structured products are created from a combination of financial instruments, their forms are quite varied – and the possible combinations of underlyings are almost unlimited.
When interest rates began trending sharply lower in the early 2000s, sales of structured products exploded as banks sought ways to offer their clients better returns.
In the early days of structured products, they were mainly composed of capital protected (or guaranteed) products: Institutional investors were promised the return of their initial investment plus a premium if the buyer’s expectations were met. If the actual return fell short of the target, the investor received their initial capital at maturity.
When selling a structured product, the issuer must provide a term sheet to the buyer.
This technical document explains in a clear and intelligible way how the product works by describing the different risks to which the investor is exposed. It must give different possible scenarios of the product’s evolution in certain market configurations (favorable scenario, median scenario and unfavorable scenario).
Structured products are usually divided into two main categories: Growth products and yield products.
The buyer of a growth product benefits from part of the performance of an index at maturity, with or without a capital guarantee. A “bull note” product, for example, returns the investor’s initial capital plus a percentage of the performance of the CAC 40 index at maturity. So, if a bull note offers a 30% stake at the end of three years, the product promises to return the initial capital + 30% of the rise in the CAC if the index rises; if the CAC falls during those three years, the buyer receives just the initial capital at maturity.
A yield product, meanwhile, defines a periodic income stream, or “coupon,” that is paid to the buyer if a predefined scenario occurs. (Often these periodic payments are annual in Europe and semi-annual in the United States.) One of the best-selling types of such products is a Phoenix note, which is designed to pay a regular coupon as long as the underlying stays within limits specified in the term sheet.