How to take exposure to credit via structured products
Credit structured products offer not only diversification compared with other asset class but also an alternative to holding bonds in the same asset class: Credit.
Structured products allow investors to use extremely varied investment strategies while adjusting their risk-return profile. Apart from equities and Forex, another investment universe associated with structured products is Credit.
What is a Credit structured product?
Credit structured products take the form of a wide variety of products and are therefore suitable for all investor profiles: conservative, experienced and professional.
The common denominator of the investment vehicle is the notion of credit risk or the issuer’s default risk (and therefore for the investor, a partial or total loss of the capital initially invested). The investor’s understanding is key, representing the prerequisite for all investments in a Credit structured product. The investor has numerous indicators, including credit ratings published by rating agencies. Cautious is needed, however, because these ratings reflect the independent opinion of rating agencies and should not be considered as a guarantee of credit quality.
Investing in a credit structured product means monetizing an opinion on credit risk by playing the non-occurrence of a credit event on the selected underlying asset(s), irrespective of the structure of the product.
Let’s look at a bond basket which issues a floating coupon with a floor rate. The investor will receive all the coupons, and at maturity, all the capital invested if no credit event affecting the entities (in addition to the credit risk on issuer) in the basket has occurred during the life of the product.
There are 3 main Credit events: bankruptcy, payment default and restructuring.
Two types of exposure to credit risk
We distinguish 2 types of exposure to credit risk: cash (if via bonds) and synthetic (if via derivative instruments, e.g. CDS*). One of the specificities of the synthetic approach is that it helps to create a tailor-made product, by eliminating constraints linked to the debt market (where bonds are traded), such as maturities, currencies or liquidity. An investor who does not find on the market any available bonds from a specific entity (the case in certain emerging markets) may turn to a synthetic product.
Benefit from a specific framework
By investing in a Credit structured product via the synthetic approach, the investor benefits from a regulated and standardized framework which is specific to Credit. All the terminology used is defined legally. A professional body (ISDA) comprising the main participants (840 members in 64 countries) is responsible for putting in place standards and procedures to supervise the activity and define default. This helps to minimize legal risks and manage conflicts of interest between counterparties.
A diversification tool
As for equities or currencies, credit is a separate asset class in which an investor seeks to obtain an optimized revenue. Indeed, beyond the simple nominal return, it is possible to arbitrate between the return of the bond and the synthetic bond relating to the same reference entity. The difference between these two returns is known as the base.
In an investment portfolio, Credit structured products offer not only diversification compared with other asset classes but also an alternative to holding bonds in the same asset class.
For more information on Structured Products, see our pedagogical brochure available on our app: “Voice of Wealth”.
*Credit Default Swap