Are structured products senseless high-risk instruments that should not have been offered to retail investors?

No. On the contrary, they are instruments that offer value to investors if sold to those with the right matching profile in terms of risk appetite, expected returns and future cash flow needs. Structured products, as the name implies, are created by bundling several financial instruments together.

By combining different instruments, a wealth manager is able to adjust the payoff, risk and maturity period of the product to match the expectation and profile of the investor. At the private banking level, they are often referred to as tailor-made investment solutions.

We can see that these are customer-centric products. They create value for investors by offering customised payoffs and risk levels that are different from other basic financial instruments such as normal bonds and stocks.

The industry generally classifies structured products into two categories - capital-protected and non-capital-protected. Often the former is referred to as a low-risk investment as the capital is protected. Unfortunately, this can be misleading.

There are two issues that are often not clearly explained or understood about capital-protected structured products. Firstly, capital protection is not the same as capital guarantee. A capital-protected structured product is not protected against credit risk. We should know that even a simple $100,000 fixed deposit is also not capital-guaranteed. The investor will suffer a capital loss if the bank goes into bankruptcy. A capital-protected structured product is protected against market risk, not credit risk.

Thus a capital-protected structured product can be a very high-risk instrument if the credit risk of the financial instruments bundled in the structured product is high - imagine the risk when sub-prime mortgage loans are used.

Secondly, capital is protected only if investors hold the products till maturity. If investors choose to get out before maturity, they may suffer a loss of capital should the price of the structured product move against them. As such, if investors plan to use the funds over the next one to two years, they should not invest in a five-year capital-protected structured product. In fact, such investors are not even supposed to buy a five-year Treasury bond.

At times, the structured products may have to be terminated before maturity against the investor's wish to hold it till maturity. Generally, it is because of the trigger of an early redemption event, such as the situation for the Lehman Minibonds.

Are structured products good investment instruments?

Definitely, if the payoffs, risks and maturity of the structured products match the investors' needs.

Suppose you hold the view that the current stock market has over-corrected for this crisis and will revert sharply when market confidence returns. You are considering investing in the stock market at the current level but are worried that your views may be wrong and the market will fall further.

Let us say that you are prepared to take a maximum loss of 8 per cent when you invest in the stock market. A structured product that offers you a 92 per cent capital protection and a return that is linked to the return of the stock index may be exactly what you want.

If the stock index rises 30 per cent over the investment period, you earn 22 per cent, which is 30 per cent less the 8 per cent you need to earn to recover your full capital. However, should the market fall by 30 per cent, your maximum loss is capped at 8 per cent of your capital.

Similar structured products are offered by some banks to their wealthy clients in today's market. They are known as equity-linked capital-protected structured products. It is important to note that 92 per cent of your capital is protected against market risk but not the default (or credit) risk of the structured product issuer. This product has created value for the investor with the above profile.

Are structured products very complex instruments?

Yes, they can be. Some structured products are not easy to comprehend even for very seasoned wealth managers. Let us use credit-linked structured products that are similar to Minibonds and Jubilee Series 3 as an illustration of the level of complexity that it can get to.

These products are typically structured by combining a basket of bonds and a credit guarantee on bonds or debts of several companies. The investors' funds are used to buy a basket of bonds. At the same time, investors provide a guarantee on the credit risk of a group of companies and the basket of bonds bought is used as collateral for this guarantee.

The returns of the structured products come from two sources of risks borne by investors. First, the interest rates from the basket of bonds investors purchased. Second, the fees collected from the debts guaranteed by investors. Should any of the bonds default or should any credit event occur on the debt guaranteed, investors will suffer a capital loss.

Suppose the guarantee is on the debts of six companies. If a credit event occurs on any one of the six companies, the investor (who serves as a guarantor of the debt) will need to compensate the party whom they provided the guarantee to. It is usually the arranger of the structured product.

It is important to understand that the loss is not limited to one- sixth of the principal. As the guarantee is on a so-called first-to-default basis, the investor's obligation is on the first company that suffers a credit problem. When it happens, the investor's obligation on the other five companies is cancelled. The investor may not lose the entire investment as this would depend on the value of the company's debt after the credit event has occurred.

As a savvy reader, you may realise that I have been using the word credit event and not default or bankruptcy. This is because a credit event refers not only to a bankruptcy, it also covers several other credit events such as debt restructuring and failure to pay within a grace period. The definition of a credit event is quite technical in nature.

Another area of complexity is when bonds purchased and debts guaranteed are not Singapore-based and often denominated in US dollars. The exchange rate risk to investors is hedged by the product arranger.

Yet another complexity may be the type of bonds purchased. Besides being put in a basket of bonds, investors' funds can also be invested in a basket of corporate loans or consumer loans made by different banks globally, or even in a basket of credit-linked structured products.

The writer is Associate Professor of Finance at Nanyang Business School.

This article was first published in The Straits Times on October 26, 2008.