Structured products

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

• A debt component (such as a bond)
• A derivative component (such as an option)

These investments can be complex and highly tailored. To see the basic idea more clearly, we can build a simplified structured product.

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 (often the same financial firm 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 bond at maturity. If the S&P 500 declines, the option becomes worthless and provides no return.

This is just one of many ways 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 carry significant liquidity risk.

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