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Structured Bonds

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What are the structured bonds?

Structured bonds are financial products with variable yield that arise from the combination of a traditional fixed or variable debt instrument, with one or more derivative contracts. These derivative contracts are usually linked to the performance of equities, indices, currencies, interest rates or bonds. The bond component provides for the repayment at maturity of the nominal value and, if provision has been made, receipt of periodic coupons. The derivative component affects the variability of the final performance of the investment.

Bonds whose returns are linked to equity, index, currency, interest rate performances

Listing and trading

Structured bonds are financial instruments that can be bought and sold both on the MOT market (an electronic bond and government securities market) as well as on the Multilateral Trading Facility EuroTLX of the Italian Exchange , in the event they are respectively listed and/or admitted to trading on these markets. Methods and trading hours of MOT and EuroTLX are specified in the relevant Rule books, available on the website of the Italian Exchange. For example, on both markets, trading in the continuous phase may take place on the open market days between 9am and 5:30pm.


Standard features

The bond component of structured bonds, also called a host contract, has standard features. These are:

  • NOMINAL VALUE: The value that will be repaid at maturity of the bond;
  • COUPON: The period interest paid by the issuer to its bond holders;
  • EXPIRY: The date when the bond holder will be repaid the nominal value of the bond;
  • ISSUER: The company or State that has issued the debit instrument.


Yield

There are various components that impinge on the final yield of a structured bond. On the one hand there is the issue price of the bond and on the other the link to the receipt of periodic coupons (dependent on the type of rate predicted when the bond was issued, i.e. fixed or variable) and the derived component. Another factor affecting the yield of a bond is the issuer's creditworthiness: the higher the quality of the creditworthiness, the lower the yield on the bond in respect of one of the same duration and characteristics.


The issue price

In considering the issue price component of a bond, there are three possible issue prices which can be issued:

  • At par: Where the issue price coincides with the nominal value repaid at maturity of the bond (a 100 euro bond at maturity achieves 100 euro). In this case the price of the bond does not affect either positively or negatively on the overall yield of the bond at maturity;
  • Below par: The issue price is less than the nominal value at repayment of the bond. (A bond bought at 98 Euros and at maturity it is worth 100 euro). For bonds that provide for the payment of coupons, this price difference is an element that increases the overall return that the investor will receive on maturity of the investment. For bonds that do not provide for the periodic payment of coupons, so called zero-coupon bonds, the price difference is the overall return that the investor will receive on maturity;
  • Above par: The issue price is higher than the nominal value paid at maturity to the investor (a bond bought for 102 euro and at maturity will yield 100 euro to the investor). This higher price negatively affects the overall performance of the bond.


How they work

In the absence of extraordinary events that lead to the insolvency of the issuer or to the absence of the guarantee of capital repayment, those investing in structured bonds at maturity will receive the nominal value of the bond. The presence of the derivative component, with the functional objective of offering a higher return than traditional bonds, will impact on the final return profile for investors by increasing the risk of the bond. The presence of the derivative leads to possible and significant changes in cash flow over the life of the bond.


Example of how index linked bonds operate

Assuming a three year linked bond, with an issue price of 100, providing for the payment of a fixed return of 2% per annum and an extra return at maturity, and given the tracking performance of the FTSE Mib during the term of the bond has an assumed performance equal to 20%, the investor will achieve the following cash flow:


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Capital invested: 100 Capital cashed in at maturity: 126


The main types of structured bonds

Depending on the specific characteristics of the derivative component, structured bonds are classified into several major categories. The main types of structured bonds are listed below:


Linked bonds

These are bonds whose yield is linked to the performance of certain financial or real products such as shares or baskets of stocks, indices, foreign exchange rates, commodities or other underlying assets. At maturity the bond component provides the repayment of the nominal value of the bond and the derivative component could provide the optional premium, commensurate with the performance of the financial asset or real underlying asset.


Callable bonds

Callable bonds are bonds bearing a clause that gives the issuer the right to prepay the loan prior to its maturity. The option granted to the issuer allows the investor to achieve a higher rate of interest than that of the current market for instruments of similar duration and credit worthiness of the issuer


Cap and floor bonds

Cap and Floor Bonds are floating rate securities that guarantee a minimum and a maximum coupon rate. The Floor specifically indicates the minimum value of the interest rate used to calculate the coupons, even in the event of a fall in the reference rate below this level. The Cap indicates the value of the maximum interest rate that will be used to calculate the coupon rate for the investor. Any increases in market rates over and above this threshold do not translate into a higher return for the investor, as the bond, in this case will behave like a fixed rate bond.





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