Investing is not a choice to be taken lightly. Before doing so, it would be important to have at least basic knowledge of financial matters to avoid mistakes that could weigh on you over time. One of the first things to understand is that there is a difference between traditional bonds and structured securities even though they may appear to be similar products.
What are structured securities
Structured securities are more complex financial instruments than traditional bonds because they combine two different elements in a single investment:
- a traditional component;
- a derivative instrument, often an option.
It is precisely this combination that makes them different from traditional bonds. The return, in fact, does not only depend on the fixed coupons, but also on the performance of external variables such as stock market indices, shares or currencies.
The two components are not sold separately but are combined into a single product. Whoever purchases a structured security, therefore, invests simultaneously in both the bond and derivative parts.
In some cases the capital can also be guaranteed but not always. In fact, everything depends on how the product is built and the role of the derived component. Precisely for this reason, structured securities are considered more complex and require greater attention before being purchased.
What are structured bonds
These instruments also include structured bonds, i.e. those securities that offer the possibility of obtaining higher returns than traditional bonds or of diversifying the portfolio. Given their complex nature, it is therefore essential to understand how they work before investing.
They are a subset of the combined titles. More precisely, these are debt instruments issued by banks or companies, the return of which depends on market parameters.
In this case the two main elements are:
- a bond component;
- a component linked to financial instruments.
The first, often called “host contract”, can provide for the payment of periodic coupons and guarantees, in the absence of extraordinary events, the repayment of the capital at maturity. For the investor, therefore, this part offers a certain security. The second, however, has a variable return.
Thanks to this combination, structured bonds can offer higher returns than traditional bonds but with greater risk.
The final yield depends on several factors such as:
- the issue price which may be at par, below par or above par;
- any payment of coupons;
- the part connected to the derivative.
The reliability of the issuer also affects the return. A high rating, in fact, indicates a low risk of insolvency while a low rating entails higher risks, with potentially higher earnings.
Pay attention to the contract and returns
One of the main reasons why structured notes are considered more difficult to understand than traditional bonds is how they work. With a traditional bond, the investor almost always knows what to expect: if the bond has a fixed rate he already knows the interest he will receive while if it is a variable rate he knows that the return will depend on a clear parameter, such as market rates.
In combined instruments, however, the gain depends on different variables such as the performance of a stock index or specific conditions contained in the contract. For this reason, before investing, it is important to understand not only the functioning of the bond but also that of the derivative component linked to other markets.
Some examples of structured securities
Structured or combined securities, therefore, are products that combine a traditional debt component with a part whose return depends on the trend of market parameters. Among the main ones are:
- linked securities;
- bull and bear stocks;
- drop-lock titles.
Linked securities
Linked securities are bonds whose return is directly linked to the performance of an index or financial asset. The profit, therefore, does not only depend on the interest rate but also on how the market moves.
The main types are:
- equity linked, when the return is linked to a share;
- index linked, when it is linked to a stock index.
There are also other variants linked to a basket of securities, raw materials or currencies.
These products can be considered structured bonds because they arise from the combination of a traditional bond with a component linked to the performance of the financial markets.
Bull and bear stocks
Bull and bear securities are bonds in which the loan is divided into two equal parts:
- the bull tranche that grows if the reference parameter rises;
- the bear tranche that rises if the reference parameter falls.
In this way the issuer does not run any risks: what it loses on one side, it recovers on the other. The risk instead falls on investors: those who choose the bull tranche suffer losses if the market falls while those who opt for the bear are penalized if the market rises.
Drop-lock titles
Then there are drop-lock securities which are variable rate securities that initially pay coupons linked to a reference rate, such as an indexation parameter.
However, the contract includes a clause according to which, if this rate falls below a certain level which is called the trigger rate, the coupon does not remain variable but becomes fixed until maturity.
This type of bond, therefore, protects investors in the event that rates fall too much, ensuring a minimum return established from the beginning.
Are structured securities or traditional bonds better?
Choosing between traditional bonds and structured securities depends on the investor’s experience and the level of risk he is willing to accept.
Traditional bonds are simpler to understand, as the coupons and calculation mechanism are known, as well as the methods for repaying the capital. Structured securities are more complex to understand because the final return is not predetermined and depends on the performance of external variables.
