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Structured Products: Know the Risks

Structured Products: Know the Risks

The term “structured products” evokes a sense of sophistication and precision, which is precisely how they are marketed to investors.

However, a closer examination reveals that they are often more accurately described as sophisticated funding tools for the banks that issue them. Rather than meet the needs of investors, they are as likely to saddle them with unnecessary risk.

In this article, we examine how and why.

Mar 13, 2025Decoding Risks in Structured Products- 5 min
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What Is a Structured Product?

What are structured products, in simple terms? This is not an easy question to answer as they take many different forms (capital-protected notes, reverse convertibles, equity-linked notes). In general, the term refers to a combination of a fixed-income product (like a bond) and a derivative product (like an option).

The aim is to provide investors with the best of both worlds: the stability of a bond with the potential for additional growth if the market performs as expected. Since they are highly flexible, they can be designed to meet the return objectives of diverse investors. So far, so good.

The reality of structured products is much more complex - and herein lies the problem. Typically, it is the easier to understand, positive aspects of the product that are communicated to the investor, while the devil remains hidden in the details.

For example, ‘If the market goes down, your principal is protected. If it goes up, you still participate.’ The fees, opportunity costs, and risks are often buried in lengthy documentation if mentioned at all.

 

Why Structured Products Exist

Structured products did not come into existence owing to overwhelming investor demand. Even today, few retail investors wake up in the morning and call their brokers requesting a “Global Equity-Linked Callable Range Accrual Note”.

A more plausible hypothesis is that structured products provide a means of raising cheap capital for the issuers. Unlike bonds, structured product payments are mainly contingent rather than guaranteed, and settled at the end of the product term, which normally spans multiple years.

This is where the comparison to bonds becomes relevant. If an investor is comfortable taking on credit risk with a bank, why wouldn’t they just buy the bank’s bonds instead? Bonds offer a fixed interest rate, clearer repayment terms, and better liquidity. In contrast, structured products often embed additional costs and risks that are not immediately obvious to the investor.

 

Why Banks Prefer Structured Products Over Bonds

  1. Cheaper for the issuer – Bonds require the bank to pay interest regularly, whereas structured products allow the bank to defer and condition payouts, often reducing their real funding costs.

  2. Higher embedded fees – Structured products often include hidden costs, meaning the investor pays more than they would for a direct bond investment.

  3. Shifts risk onto investors – Bondholders have legal protections and a fixed claim on assets in the event of bankruptcy, whereas structured product investors often find themselves at the back of the line.

Crucially, they are designed carefully to ensure that the issuer - on average - profits from them. Alternatively put, they are designed to ensure that the investor pays - on average - more than they cost to provide. This contrasts with the way they are presented, which is often as a ‘win-win’ proposition. So, what’s hiding in the small print?

 

The Hidden Risks

First of all, a structured product is designed to deliver returns if the market behaves in a certain way. If the market is more volatile than expected, falls further than anticipated, or does much better than predicted (all of which are quite normal occurrences!) the investor can be left worse off.

One could argue that the above applies to all investments. However, in the case of structured products, there are additional drawbacks. For one, the manufacturer will often charge a substantial up-front fee, which can amount to 1.5%-2% per year - very high by today’s standards.[1]

Furthermore, unlike most other investments, there is no real liquid market for structured products as of yet.[2] This is first and foremost a problem if one’s return objectives change and the product is no longer fit for purpose. A secondary problem is that the lack of a liquid market means less transparency on what fees are fair, and on the products themselves.

Then, there is counterparty risk. If you entrust your money to a regular investment fund, it will remain segregated in a custodial account, generally insulated from the fund manager’s own financial troubles. However, when an institution issues a structured product, your capital - even if it is supposedly ‘guaranteed’ as part of the terms, could be forfeited if the bank goes under.

 

The Worst Case Scenario

Banks going out of business is unfortunately still a very real possibility. While a full-scale banking crisis was - happily - averted in 2023, the turmoil did claim a handful of prominent banks, including the Swiss giant Credit Suisse.

Still, proponents of structured products like to point to data showing that the vast majority of structured products have shown positive returns in the past 5 years.[3]

The Great Financial Crisis of 2008 provides a classic example of structured products going wrong. Lehman Brothers sold Principal Protected Notes linked to mortgage-related assets, which investors were led to regard as safe, as the underlying capital was guaranteed.[4]

The same investors (eventually) recovered only a portion of their investment after the bank was engulfed in the subsequent crisis. Unlike bondholders, they were close to the very back of the queue, with some recovering between 40 and 50 cents on the dollar after more than a decade of litigation.[5]

 

Conclusion

It is not the case that all structured products are always wrong for all investors. However, the structured products industry as a whole is troubled by a lack of transparency that typically favors the seller. Often, structured products are simply a means of borrowing money at a cheaper rate and transferring risk to the investor, on terms that the investor cannot be expected to fully understand.

For those who want exposure to a bank’s credit risk, bank bonds provide a more transparent, liquid, and predictable alternative. Bonds offer a fixed return and legal protections in case of issuer default, whereas structured products often introduce unnecessary complexity and hidden risks.

Our own philosophy at The Family Office is to avoid attempts to engineer away risk, and to focus instead on fundamentals: promising sectors, firms, and management teams. This is in many respects more difficult than financial engineering, but is more transparent, and ultimately, a path to more reliable returns.



[1] Morningstar

[2] Securities and Exchange Commission

[3] Lowes Financial Management

[4] Deng, Geng & Li, Guohua & Mccann, Craig. (2009). Structured Products in the Aftermath of Lehman Brothers

[5] New York Federal Reserve

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