Let’s start with “a simple clarification” on the construction of a structured product. It is usually made up of an option and a zero-coupon bond (ZC) from the issuer of the product, typically being a bank. The option provides exposure to the underlying, while the bond serves as the foundation on which the product is built. Let’s focus on the ZC for a moment and analyse what factors will influence it and what risks it entails.
ZC – What’s that? A ZC is a bond purchased below par, which pays no coupon and is 100% redeemable at maturity. Its price will be determined by two factors: the level of risk-free interest rates and the risk premium of the bank issuing the ZC. The higher the interest rates, the cheaper the ZC; the higher the risk premium, the cheaper the ZC. The recipe for buying a ZC seems simple enough: Buy a ZC in a currency with very lucrative interest rates and issued by a bank with a particularly high-risk premium. However, any self-respecting cook will tell you that following a recipe blindly can lead to frustration and disappointment. In the same way, the acquisition of a ZC with a high-risk premium can prove to be the ingredient that spoils the recipe, even to the point of default. So, what happens to our structured product if the issuer becomes insolvent? It is repaid at recovery value like any bank issued bond, which is much less than the original investment. Choosing the issuer with the highest risk premium is therefore sometimes a misguided idea with potentially damaging consequences. Holders of structured products issued by Lehman Brothers experienced this painfully in 2008... many of them were unaware of this risk.
Although investors have forgotten this criterion (or rather risk) over the years, it is essential to be selective in the choice of issuers. Excessively good conditions due to an abnormally high-risk premium are signals to be heeded and should encourage due vigilance. Failure to do so underestimates the risks associated with the issuer’s vulnerability and exposes the issuer to losses. Conversely, the tactical investor will see an opportunity here, but this requires prior analysis of the issuer’s credit risk and sound decision making. It is ultimately up to the investor to judge whether the risk is worth it... “for the love of risk”.