Structured bonds can provide regular income in the form of coupon payments under predetermined terms even when the market is down.
A structured bond is a type of security in the form of a bond in which payments to the holder are contingent upon the occurrence or, conversely, non-occurrence of certain conditions.
Such conditions may include:
- fluctuations in the prices (rates) of the underlying assets – stocks, bonds, currency, commodities, etc., as well as changes in inflation and interest rates;
- fulfilment or non-fulfilment of obligations by legal entities, states or municipalities (except for surety and insurance contracts);
- other circumstances stipulated by federal laws or regulations of the Bank of Russia.
The investor’s profit from structured bonds consists of its nominal value, coupon income, and possible additional income, if such a condition is present.
Compared to ordinary corporate or government bonds, the yield from structured bonds may be higher, but the risks are also significantly higher.
How structured bonds function
By purchasing a structured bond, an investor is actually investing in the underlying asset that forms the basis of the bond, without actually owning it.
The scenarios affecting the yield are set out in the issuance documentation, which must be available to investors prior to the placement. The issuer is obliged to inform in advance about the payment procedure.
Examples of situations on which the yield on a structured bond will depend.
If the shares of company ‘X’ increase by 22% in three months, the investor will receive income from this increase. The amount of the gain is determined by the participation rate, which is also given in the issue documentation. For example, if the participation rate is 90% and X’s stock has increased by 1,000 ₽ – on the day the bond matures, the investor will receive its face value and an additional 900 ₽ from the growth.
If the trading strategy is ineffective, the investor risks not only not earning the additional funds, but also receiving less than the face value of the bond at maturity.
This situation is also set out in the issue documentation.
Example:
An investor purchases a 1000 ₽ structured bond linked to the shares of company ‘X’, the underlying asset.
The return of par at redemption depends on the share price of ‘X’ company’s shares compared to their original documentation price. If the share price falls by more than 10% of the initial price, the investor will only receive 80% of the par value, i.e. 800 ₽.
Structured bonds are classified according to the level of capital protection as follows:
- Bonds with full capital protection: they provide a guaranteed return of the invested amount (i.e. nominal value), while the income in the form of coupons depends on the realisation or non-realisation of certain conditions;
- Bonds with partial capital protection: neither the amount paid at maturity nor the income is specified in advance, but the issuer sets a minimum return amount that serves as a risk barrier, e.g. 80%;
- Bonds without capital protection: the issuer does not guarantee a minimum repayment amount.
Thus, both the amount of income and the return of par on such securities depend on fluctuations in the prices and/or values of other assets or indicators to which the bonds are linked.
Owners of structured bonds have the option to sell them before the maturity date, but since each issue is unique, it is unpredictable when a buyer will be found.
The market value of these bonds is affected by a variety of factors, including changes in commodity prices, exchange rates and other financial indicators.
Structured bonds are a high-risk financial instrument and are intended for qualified investors. In addition to credit risk, they also carry the risk of capital loss and income shortfall due to changes in the prices of the underlying assets.
In addition to credit risk, investments in structured bonds may involve the following additional risks:
- The risk of losing part of the capital when the protection is incomplete, as mentioned earlier;
- The risk of no income, as changes in the prices of the underlying assets may lead to the redemption of the bond without payment of additional income.
At the same time, if the capitalisation of the issuer of a structured bond changes, this is not considered a risk, unlike traditional bonds where capitalisation plays a key role for investors.
How do structured income bonds function?
These bonds are exchange-traded instruments, at their redemption the investor receives the nominal value as well as one of the types of income:
- non-guaranteed coupon income (provided in the issuance documents as a formula with variables whose values cannot be changed at the issuer’s discretion);
- guaranteed coupon income specified as a percentage of the face value, and optional additional income described through a formula with variables.
With conventional or classic bonds, the investor knows his or her coupon income in advance, whereas with structured income bonds this information is not available. This brings them closer to structured bonds. However, unlike the latter, the payout cannot be less than the par value at maturity of structured bonds. Therefore, such securities are available to unqualified investors who have passed preliminary testing.
Since the value of a structured income bond and its income depend on fluctuations in the price of the underlying asset and fulfilment of certain conditions, there is a risk for the investor to receive incomplete income. At the time of placement of the bond, it is impossible to determine exactly how much it will yield, as only the calculation procedure is known, but not the specific data for it.
As an example, the terms of payment of non-guaranteed coupon income or additional income on such bonds may serve as an example.
An annual return of 16%, which is not guaranteed, can be obtained thanks to four quarterly coupons of 4% on bonds that depend on the shares of companies A, B, C and D.
However, this income will only be paid in a quarter if none of the specified stocks – A, B, C or D – fall in price by more than 10%. This means that receiving this income is not a guarantee.
In addition, the amount of this income may depend on the value of the underlying asset or other conditions, which is a so-called floating coupon.
It should be borne in mind that past increases in underlying asset prices do not guarantee future increases, and relying on historical dynamics in the hope of receiving a coupon may be misleading.
The issuer determines the coupon payment terms and the coupon calculation process for investors when redeeming a structured income bond prior to its placement, which allows the investor to carefully assess all possible risks.
For a clearer understanding, here is another example.
An investor has purchased a structured income bond. The coupon will be paid at maturity of the bond only if the share price of company ‘X’ on the valuation date is higher than the starting value. This means that in such a case the investor will not only receive the face value and fixed coupon on the bond, but also additional coupon income.
Now let’s see how this condition worked in practice. On the valuation date the share price was 1% lower than the starting value, while at the moment of coupon payment the share price was 5% higher than the initial amount.
According to the terms, we are interested in the value of the reference asset on the observation date, and it turned out to be below the required level. As a result, at the end of the term, the investor will receive only the nominal value of the bond.
Determining the coupon rate for structured income bonds is a difficult task. Investors have knowledge of the calculation method, but do not have accurate data on the market value of the asset or other financial parameters that influence the coupon amount.
Since coupon payments – the key income on these bonds – are affected by various factors, these same characteristics also affect the market value of the bond itself, as well as its price on the secondary market. It is impossible to assess this relationship and accurately predict how the bond’s value will change as the price of the reference asset – for example, the stock to which it is linked – fluctuates. As a result, the investor faces the risk of possible financial losses in case of early sale of the bond.
Bottom line
Structured bonds have several features that are important to consider when making an investment decision:
- Risks. Like any other investment, structured bonds come with risks. It is important to understand that fulfilment of the conditions inherent in the bond structure is not guaranteed. If the conditions are not met, the investor may lose some or all of the investment amount.
- Yield. Structured bonds may offer a higher yield than regular bonds, but this is not always the case. The yield depends on the conditions inherent in the bond structure and can be either higher or lower than the yield on conventional bonds.
- Conditions. The conditions inherent in the bond structure can vary. They may include achieving a certain level of yield, changes in the price of the underlying asset, fulfilment of certain events (e.g. merger of companies), etc. It is important to carefully review the terms of the bond before making an investment decision.
- Terms. Structured bonds can have different maturities. Some bonds may have a short duration (a few months or years), while others may have a longer duration (several years or decades). It is important to consider the timing of the bond when making an investment decision.
- Liquidity. The liquidity of structured bonds can vary. Some bonds can be easily traded in the market, while others are less liquid. It is important to consider the liquidity of the bond when deciding how to invest.
- Taxation. Taxation of structured bonds can vary from country to country and law to law. It is important to research tax laws before making an investment decision.
In general, structured bonds can offer investors higher returns, but they also come with risks. It is important to carefully consider the terms of the bond, the risks and possible consequences before deciding to invest in structured bonds.
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