What is a Structured Title and the Types to Know

On the stock market, structured securities have become increasingly discussed and used financial instruments by both institutional and private investors. With markets constantly evolving and interest rates undergoing unpredictable fluctuations, the need for instruments capable of offering protection and potential returns has made structured securities an interesting choice.

But what are they exactly? What advantages and risks do they entail? And, above all, how are they distinguished - if they are distinguished - from structured bonds?

Let’s analyze in detail the meaning of structured security, its main characteristics and some practical examples to better understand how it works.

What are structured securities: meaning and definition

To give a definition right away, we can say that:

structured securities are complex financial instruments: they incorporate within them a traditional debt instrument and a derivative contract. The latter is generally an option that includes a right to buy or sell underlying financial instruments such as indices, shares or currencies.

In essence, these securities offer a combination of fixed and variable returns, often linked to the performance of stock indices, interest rates or currencies.

Unlike "traditional" bonds, the two components of a structured security, i.e. the bond and the derivative, are merged within a single financial instrument. What differentiates them from traditional bonds is the yield, which is regulated based on parameters linked to the occurrence or non-occurrence of certain events foreseen in the contract.

These products can be used to diversify the portfolio, cover specific risks or seek opportunities for higher returns than traditional investments.

Are structured bonds and structured notes the same thing? How do they work?

Although the terms are often used interchangeably, structured notes and structured bonds are not exactly the same thing. Both combine a bond component and a derivative component, but have significant differences in terms of structure, operation and purpose.

Structured bonds are a subset of structured notes. They are debt instruments issued by a bank or a company, whose return is linked to market parameters such as interest rates, stock indices or currencies. For example, a mixed-rate bond may pay a fixed coupon for the first few years and a variable coupon thereafter, based on the performance of a benchmark index.

structured securities, on the other hand, may not have a traditional bond component and may include more complex derivatives, such as exotic options or swaps. This makes them more flexible but also riskier instruments.

Types of structural securities

We have seen what structural securities are and what their peculiar characteristic is. Structural securities can be guaranteed capital, in the case in which the interest payment flows are indexed to the performance of the parameter underlying the derivative component. Alternatively, they can be non-guaranteed capital and in this case the repayment value may be lower than the subscription value.

From the issuers’ point of view, the structured market is the almost exclusive domain of banks, financial institutions and supranational bodies. Based on the nature of the underlying parameter, structured securities are divided into various categories. Below are the characteristics of the main types of structured securities.

Reverse floater securities

Reverse floaters are floating rate bonds with reverse indexation. Initially issued at a fixed rate, these securities incorporate a contract that, starting from a certain date, has the effect of changing the rate from fixed to floating.

These are generally long-term securities (10-30 years) that pay initial fixed coupons that are higher than current market rates. Subsequently, the buyer receives a floating rate given by the difference between a predefined maximum ceiling (often very high) and a floating rate that could be the Euribor.

It is possible to break down the purchase of a reverse floater into:

• a long-term bond with a fixed coupon;
• an interest rate swap with an effective date coinciding with the settlement date of the last fixed rate coupon of the security;
• a series of interest rate cap coverage.

The first component gives the holder the right to receive reimbursement of the nominal value at maturity, while the derivative component determines the mechanism of variability of the periodic coupons.

The periodic coupons (annual or semi-annual) are in fact equal to the difference between a fixed interest rate determined in the loan regulations and a variable interest rate.

Often the swap contract incorporated in the reverse floater is a "non par swap"; in this case the variable coupon will be equal to the difference between the fixed rate and the variable rate multiplied by two.

Step-up and step-down bonds

A further distinction in the context of reverse floaters is between "step-up" and "step-down" bonds, expressions that refer to the first period of coupon flow, the one in which the amount is fixed: for "step-ups", the sum paid with coupons is increasing, for "step-downs" the sum is decreasing. After this first phase, the variability mechanism comes into play.

The volatility of the price of the reverse floater is greater than that of a normal variable coupon security with similar characteristics and it is therefore a security for risk-loving investors.

Linked securities

They are bonds whose yield is linked to the performance of certain financial or real products, such as shares (equity linked), indices (index linked), exchange rates (forex linked), raw materials (commodities linked), mutual funds (funds linked) or other financial instruments.

The interest rate paid is generally lower than the market rate and at maturity the repayment at par of the loan is guaranteed. However, the buyer has the advantage of being able to obtain a premium at maturity based on the performance of the underlying financial product.

By subscribing to an index-linked bond, you are in fact buying both a bond and a call option on the underlying index. The option is not free, the issuer recovers the cost of this by paying an interest rate lower than the market rate.

The investor, therefore, bears the typical risk of the buyer of an option: as time passes, the option loses value and only if the performance of the underlying stock exceeds the strike price set at the time of issue will he receive some coupon flow.

A simpler version of a linked bond provides for the payment of only the premium at maturity, without the payment of interest coupons. In this case, the premium also incorporates the flow of coupons not paid during the life of the loan.

Bull and bear bonds

Bull and bear bonds, also called "bull and bear", are fixed rate securities in which the repayment of the capital depends on the performance of a parameter that can be a stock index, the price of another financial asset, the pre-established exchange rate between two currencies or the rates on government bonds.

The loan amount is divided into two tranches of identical value, but with different methods of repayment of the capital at maturity.

• In the first tranche (bull) the repayment value varies (with respect to the repayment price in the absence of variations) in a manner directly proportional to the variation in the performance of the reference asset.
• In the second tranche (bear) the repayment value varies inversely proportional to the variation in the performance of the reference asset.

In this way, the issuer is not burdened by any risk connected to the performance of the stock market and the investor can subscribe to a security belonging to the bull tranche or a security belonging to the bear tranche, depending on his expectations on the performance of the market.

The subscribers whose expectations have been verified (for example, those who have subscribed to a security belonging to the bull tranche) will obtain a capital gain equal to the loss suffered by those who have purchased the tranche linked to the expectations of the opposite sign (for example, bear tranche).

Drop-lock Securities

The drop lock bond is a variable rate security that pays the holder coupons indexed to an underlying parameter. The bond incorporates a clause such that if the indexing parameter falls below a certain limit (called "trigger rate"), the subsequent coupons will be counted on the basis of a fixed rate, established in the issuance regulations, which can be equal to or higher than the trigger rate.

Essentially, this bond incorporates a "guarantee" that protects the holder from an excessive fall in interest rates, guaranteeing a minimum fixed return.

Callable and putable securities

Bonds called callable and putable provide for the possibility of being early reimbursed, with the difference that for callable bonds, the possibility of early reimbursement belongs to the issuer. For putable bonds, however, it is the investor who has the right to request early reimbursement.

Callable bonds are composed of a normal fixed-rate bond and a call option in favor of the issuer, desired by the issuer itself to protect itself from falling interest rates.

The buyer of a callable option expects a certain stability in the trend of rates, but simultaneously also fears a rise in interest rates.
Putable bonds are composed of a fixed-rate bond and a put option in favor of the subscriber. The investor exercises the put option in the event of an increase in interest rates because he can sell the bonds at a contractual price higher than the market price.

Securities with maximum and/or minimum coupons

These are variable coupon bonds in which there are limits on the increase or decrease in coupons. These limitations can occur alternatively or even simultaneously within the security.

Securities with maximum coupons provide a maximum limit on the growth of coupons: the value cannot go beyond the established threshold. This is a protection in favor of the issuer, who is exposed to the risk of rising rates.

Securities with minimum coupons, on the other hand, provide a limit on the decrease in coupons. These securities include a minimum value that protects the investor from falling interest rates.

Credit linked note

In these bonds, the indexation does not refer to cash flows, but to the credit risk of the security. In these structural securities, the indexation does not refer to cash flows, but to the credit risk of the security. Credit linked notes include:

• fixed coupon bonds;
• a credit derivative, i.e. an insurance sold by the investor to the issuer, which provides coverage linked to the occurrence of a particular credit event, such as insolvency.

In the event that the credit event occurs, the issuer of the security has the right to suspend the payment of coupons to investors.

Original article published on Money.it Italy. Original title: Cos’è un titolo strutturato e le tipologie da conoscere