Structured products

A structured product is a customized investment vehicle created by financial firms for specific types of clients. It typically combines two pieces into a single investment:

• A debt component (often a bond)
• A derivative component (often an option)

These investments can be complex and highly tailored. To see how they work, it helps to build a simplified example.

Let’s assume an investor wants to invest $100,000 and earn the returns of the S&P 500 over a 5-year period, while also protecting against a bear market. A financial firm could create a structured product with these two components:

• $80,000 zero coupon bond ($100,000 par value)
• $20,000 S&P 500 index call

The zero coupon bond component provides the principal protection the investor is looking for. As long as the bond’s issuer (usually the financial company creating the structured product) does not default*, the bond will mature at $100,000 at the end of five years. Even if the S&P 500 index call expires worthless, the investor still receives $100,000 at maturity.

*Because default is possible, structured product investors must be comfortable with credit risk.

The S&P 500 index call is bullish on the index. If the S&P 500 rises, the option gains value, and the investor receives those gains in addition to the $100,000 principal from the zero coupon bond. If the S&P 500 declines, the option may expire worthless, producing no additional return.

This is just one way to build a structured product. In general, any combination of two or more financial instruments packaged into a new customized investment can be considered a structured product. Because these products are customized, there’s typically no public secondary market for them. As a result, most structured products involve significant liquidity risk.

There’s one primary exception to keep in mind. Exchange traded notes (ETNs) are technically structured products, but they trade on stock exchanges. When a financial instrument trades on an exchange, liquidity risk is generally very low. ETNs are one of the only structured products that can typically be assumed to have little-to-no marketability problems.