Belfast Telegraph

Sunday 13 July 2014

The name is bond, zero coupon bond

The question I am asked most frequently these days is, of course, “Where would you put your money right now?”

But those investors who spend time reading, researching and poring over the Sunday supplements to find out what is on offer are also asking about “structured products”.

What they want to know is exactly what they are and how they work.

Why? Because they contain one magic word — “guaranteed.”

The problem is that many do not read past this word to make sure that they understand what is being guaranteed and what strings, if any, are attached to that guarantee.

So I thought that an attempt to explain some of the jargon that surrounds structured products might be of help to those who are considering buying one.

Let’s begin by looking at how they are made up.

There are essentially two elements:

  • a zero coupon bond, which provides the capital protection and
  • a package of options to give the required upside profile.

The bond has had its income stream stripped out and is designed to give a certain level of growth over a set term.

However a product is likely to use other financial instruments such as derivatives, debt issuance or swaps in its make up.

So let’s be clear — a bond is a debt instrument issued by a company which can be listed on a stock market, or not, as the case requires.

The upside is the potential for growth offered by the product provider.

There are two types: An income product or a growth product.

The growth product offers a participation in the rise of an index over a stated period of time (typically three, five or seven years).

For example, a participation rate of 100% would generate a return exactly equal to the rise in the index — effectively a tracker.

I refer to a ‘rise’ in an index but, as we have all seen, indices can fall as quickly as they can rise, so you have no guarantee of getting your money back — unless the terms of the product say so.

This leads me on to the next important thing to understand — capital protection. Structured products often provide a level of capital protection for investors.

Frequently this is defined as a percentage of the capital at risk or secured (for example 100% capital protection should return all of an investor's money no matter what happens to the underlying index).

However, capital protection is usually dependent upon the product provider or, more importantly, the issuer of the underlying asset(s) being solvent at the maturity date of the product, in order to provide the stated returns.

This is one of the reasons why protected products cannot be referred to as guaranteed, as there is a risk if the counterparty defaults on their obligations.

So there you have the next problem, which is counterparty risk and which you need to be sure about before parting with any money.

Remember that certain banks have suffered severely by having to cover counterparty risk.

There are income products, which give a defined income over a period but most will only partially protect your capital.

You may, in addition, encounter such words as a ladder, a cliquet, a himalaya or a strangle.

And, just when you thought it could not get any sillier, you can also have a napoleon.

Many products work on a basket of indices and there are different ways of calculating how each works to give you your eventual return.

So all that these extraordinary words refer to, is the type of return you may get from a particular product.

As usual, there is only space in this column to take a glimpse at the mountain of jargon |surrounding this particular product, but I have two final points.

First, your money is generally tied up for the investment period and will be very difficult to access during this time.

Second, you will need to find out how you will be taxed on any return from the product.

Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority. To contact him, use the website www.realwealthmanagers.co.uk

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