This article turns to a second risk: the credit of the issuing entity. This risk is not related directly to market conditions but is specific to the financial condition of the company which sold the product.
What is issuer risk
Structured products are designed and packaged by financial service providers, known as “issuers,” who are bound contractually to fulfill certain duties on your behalf and pass any return, net of fees.
However, since you are buying a “contract” rather than an asset, a risk exists that the issuer may be unable or unwilling to honor the contract, even if the underlying scenarios play out as envisaged.
Another aspect relates to the risk of default on the loan embedded into the structured product. Such loans are usually unsecured and rank below other creditors in the event that the issuer is liquidated following a default.
An example
Consider a principal-protected note with an embedded call option on the NASDAQ Composite Index. If the NASDAQ grows, you will participate in the upside, otherwise only your original capital would be returned.
If the NASDAQ does indeed grow in line with your best expectations, making the call option very valuable, you are still reliant on the issuer to honor the call option and repay the note.
Under adverse macroeconomic conditions, such as a global recession or financial crisis, your initial capital still might be at risk should the issuer become insolvent. Since buyers of structured products are not depositors, their claims would be subordinate to a host of other creditors, rendering the possibility of recovery remote after an insolvency.
Even if the issuer is rescued through a bail-out or sale to another financial institution, the conditions of these actions may include a write-off of all subordinated claims on the issuer, including bondholders, unsecured lenders and shareholders.
This scenario may seem unlikely in an age of well-capitalized banks and stringent regulations on banking reserves. But it is worth remembering that we have narrowly avoided a global banking crisis earlier this year. The timing of such crises and their victims are always unpredictable.
The above example shows the hidden risk associated with even the simplest structured products. As we have previously discussed, it is much harder to predict how more complex structured products react to market changes.
Comparison with private market investments
When you invest in a private market fund, you invest directly in known underlying assets, and the direct nature of the investment affords the general partner to have an insight into the underlying assets, be it equity or debt in a company or real estate, which offers a degree of risk mitigation.
In the case of private debt, the risk of default is defined clearly, often backed by known assets, which can be diversified across several companies and even geographies.