A structured product is an investment that is created to provide investors with a specified return or pay-off after a certain term. A guarantee on all or part of the capital is often part of the deal.
The products are issued by banks or insurers and provide a cheap form of debt for these companies, typically by linking a lower-risk bond to a higher-risk derivative.
The derivatives are used to obtain specific market exposures while the bonds provide various levels of capital protection that are tailored to suit the investor.
Enjoying capital guarantees and certainty on the pay-off comes at a cost, however. The trade-off is investors give up liquidity and possibly some returns – the products have a term and investors may give up some returns and/or dividends on the asset to which the pay-off profile is linked. The costs of the products can also be high.
Originally, these customised products were offered to high-net-worth individuals to allow them to participate in the best that certain markets had to offer and to shield them from the downside.
Since the first iterations in the late 1990s and early 2000s, these products have become accessible to more individual investors as well as to asset managers, companies, trusts and retirement funds as both local and offshore options.
The products have also evolved and some now provide enhanced yields with geared or leveraged returns. The trade-off for enhanced returns is a limit on the protection offered when markets are falling. What are the components of a structured product? Structured products typically have:
- An investment term – typically between one and five years.
- An explicitly stated pay-off or return that includes:
1. A linked or reference asset, such as an index, commodity or basket of stocks, interest rate, currency or a combination of a number of these. They can be exposed to different asset classes, geographies and currencies. Some products, known as rainbow structured products, have multiple underlying assets and the return may be linked to the best, worst or average of them.
2. A participation rate – for example, 100% or 200% of the return of an index. So, if the index is up 30% over three years, the investor participating at a rate of 200% would get 60% on their investment.
3. Possibly a cap on participation – for example, the product may state that if an index is up more than a certain percentage, an investor may participate fully in the returns up to that level only or may participate fully in returns above that level.
4. The conditions under which the pay-off is provided – for example, on condition the specified index or portfolio has not lost relative to the level it was at when the term began. This means that if the index or portfolio is on the same level or higher than it was when the investor invested, the pay-off will be made.
• Possibly a guarantee on capital or a portion of the capital or either of these based on certain conditions being met. The guarantee is referred to as hard or soft depending on whether it guarantees all the capital or only a portion of it. When only a portion of the capital is guaranteed, a barrier or threshold on the underlying asset is specified and if the asset falls below that barrier, the investor’s capital is no longer protected. This means the product typically fails to give protection when the market is severely down. For example, capital may be guaranteed as long as the specified index or portfolio has not lost more than 30%. Some products have no guarantees. An exchange traded note is a structured product that offers no guarantee on capital – the investor has full exposure to the return of the asset to which the pay-off is linked.
Depending on the pay-off profile and the guarantee, a structured product may:
• Provide capital back if the reference asset is negative after the term.
• Provide capital plus a specified return on the reference asset if it is positive after the term.
• Provide capital plus the full return of the reference asset if it is above a certain level after the term.
Some products have pay-offs that provide periodic payments throughout the term.
In strong bull markets, investors will typically do better fully exposed to the reference asset. But when markets are volatile, drifting sideways, growing moderately or outcomes are uncertain, structured products can provide diversification of returns and guarantees that protect against market losses.
Issuers design products to suit market conditions, and they are typically offered in tranches at times chosen by the issuer.
Investors are usually notified about a new tranche four to six weeks before what is known as the “strike date” when the product’s term begins. In that time, referred to as a “bookbuild” or “subscription period”, investors’ funds are parked in a money market account.
How do structured products work?
In order to provide the pay-off and the guarantee, the investment in a structured product is not actually invested in the linked asset. Instead, the investment is split between a bond, or some other fixed deposit, and a derivative, such as an option on the linked asset. The bond or deposit guarantees the capital while the derivative provides the returns.
For example, a structured product that provides a guarantee on capital and a fixed return if an index is positive or level with its starting price over the term, may make use of a zero-coupon bond and an option on that index.
The zero-coupon bond is bought at a discount to its face value but matures at the value of the capital invested in the structured product. This ensures the capital can be returned at maturity regardless of how markets perform. The discount on the bond is used to buy an option, swap or forward over the index or any other securities to which the pay-off is linked.
Typically between 70% and 80% of the investment is used to buy the guarantee, between 10% and 20% is used to buy the derivative and the remaining percentage is used for the costs of setting up the structured product.
At the end of the investment term, or in some cases at various points during the term, if the index or reference asset meets the predetermined level, the option is exercised and provides the pay-off. If the reference asset or index has not met the required level, the option is not exercised and only the capital is returned to the investor.
The use of derivatives also provides the opportunity to offer returns that are multiples of the linked asset. However, the cost of offering this geared return typically means investors do not enjoy full protection if the market falls. These products may, for example, only offer capital back if the market does not fall by more than 30% or 50%.
Who sells structured products?
Structured products may be distributed by insurers or securities businesses, often within an insurer, but structured notes are issued by insurers or banks such as Absa, FNB, Investec, Nedbank, RMB or Standard Bank in South Africa or by big offshore investment banks such as BNP Paribas, Credit Suisse, JP Morgan, Goldman Sachs, Barclays or SocGen.
These notes are often listed but the investor’s investment remains on the balance sheet of the issuing bank or the insurer.
The big banks often prefer not to distribute these products directly to advisors but partner with securities businesses that can prove they have the relevant Financial Advisory and Intermediary Services (FAIS) licences and key individuals. These businesses in turn work with advisors and can even provide advice directly to investors when the advisor does not have the appropriate licence.
To sell structured products in South Africa, a Financial Services Provider (FSP) needs to be specifically licensed by the Financial Sector Conduct Authority (FSCA) for the “structured deposits” financial product subcategory, which falls under the main Category I, II or III licence, depending on the services offered.
Notes listed on a stock exchange carry the name of the issuing bank – not the name of the distributor.
Whether structured notes are listed on local or offshore stock exchanges, they can be accessed directly on exchanges or from linked investment service provider platforms that list them. From these platforms they can be included in discretionary investments or in wrappers, such as endowments, living annuities and retirement annuities.
Where did they originate?
Structured products had their origins in the UK in the 1980s and 1990s. The first South African structured products were offered in 2000 and their timing coincided with the relaxation of exchange controls and increased interest from high-net-worth investors in investing offshore.
These investors were looking for a safe way to diversify into global markets and structured products linked to global indices and with a capital guarantee provided the solution. In 2008, the JSE started listing structured notes. This opened the market up to investors who did not want to invest using a foreign currency as the notes listed on the JSE are what is known as inward listings and are rand-denominated. The local listings also reduced the investment minimums for investors using platforms that enable fractional share ownership.
The JSE has introduced certain listing requirements for structured products – since November 2024 these are set out in the JSE’s Debt and Specialist Securities Listing Requirements. In terms of these requirements, issuers must:
- Be a bank or entity guaranteed by a bank, a bank controlling/holding company or entity guaranteed by bank controlling/holding companies or an insurer or insurer controlling company (as per the Insurance Act).
- Demonstrate expertise in issuing securities or access to such expertise.
- Have net assets of at least R30-billion or provide a suitable third-party guarantee acceptable to the JSE.
- Disclose their details, including company structure, directors and financial position.
- File placing and pricing documents that disclose certain information about the product’s structure and costs.
As it is difficult to find buyers to trade listed structured notes, the JSE’s listing requirements oblige issuers to unwind products if investors want to withdraw early. Investors who do not hold the product to term will realise the value of the underlying instruments less costs and will not earn the promised pay-off. The JSE also obliges issuers to publish the amount an investor will realise – the unwind level – daily.
Some distributors create structured products in response to investor needs identified during the advice process. Once it is created and listed, the distributor may offer it to both professional investors and financial advisors.
Structured products can be included in endowments or sold directly to clients through businesses with a stockbroking licence for JSE-listed products or an offshore custodian account for products listed on overseas exchanges. Benefits of using an endowment policy Investment minimums for endowments are often high – from R100 000 to more than R1-million, but investing in a structured product through an endowment policy comes with a number
of benefits:
• Tax benefits for those with higher tax rates
Life insurance companies pay income tax on behalf of the investor at the life company tax rate of 30% and capital gains tax at the rate of 12%, creating a tax benefit for anyone with a higher marginal tax and higher effective capital gains tax rate.
• Beneficiary nomination
Investors in endowments can nominate beneficiaries which means the investment is not included in the investor’s estate for executor’s fees. Investments distributed to heirs other than a spouse will still be included in the investor’s estate for estate duty purposes.
• Creditor protection
Endowments also offer protection from creditors after the first three years.
• Offshore inheritance issues
Using an offshore endowment saves investors from any offshore inheritance tax issues.
How have they performed?
It is not possible to compare the performance of structured products in the way that investors can compare other investment products such as unit trusts with a similar investment universe. This lack of transparency means that in order to determine how structured products perform, one has to get feedback from issuers and distributors of products.
Brian McMillan, a member of Investec’s structured product team, says that Investec has issued more than a hundred structured products with only 4% returning only capital to investors. The rest have delivered on their pay-off lines.
Francois Strydom, portfolio manager at Momentum Securities, says Momentum Securities has had 10 products that have matured, with two only giving back capital and the rest all calling positive.
Craig Sher, chief product and investment officer at Discovery Invest, says Discovery has issued 10 structured products that have matured so far, with all but one delivering a positive return. The one that returned capital to investors matured in 2020 during the pandemic when markets were sharply down, so investors were relieved to have not suffered losses.
