Exploring Structured Products: Opportunities and Considerations (Part II)

The investment landscape in India has witnessed a surge in the popularity of structured products, offering an intriguing blend of potential gains and risk management. These innovative financial instruments have captured the attention of diverse investors seeking tailored investment solutions that align with their risk appetite and financial goals.

An Insight into Structured Products

Structured products represent a category of investment vehicles that combine multiple financial components to offer unique risk-return profiles. These components could include traditional assets such as bonds, equities, and options. Structured products are meticulously designed to provide exposure to underlying assets while incorporating risk management mechanisms to mitigate potential downsides.

The allure of structured products lies in their versatility. They are adept at catering to a wide range of investor profiles, from risk-averse individuals seeking capital preservation to those willing to embrace market volatility for potential higher returns. Structured products are designed to optimize returns under specific market scenarios, making them an intriguing proposition in both bullish and bearish market conditions.

Structured Products Market Dynamics

The structured products market is a dynamic arena with various participants, including financial institutions, investment banks, asset managers, and individual investors. Financial institutions and investment banks play a pivotal role in structuring and issuing these products, aligning them with prevailing market trends and investor preferences.

Structured products can encompass a diverse range of underlying assets, from equity indices to interest rates. Investors are drawn to structured products due to their potential for enhanced returns, principal protection, and reduced volatility exposure. However, these advantages are often accompanied by intricate features and potential complexities, necessitating comprehensive understanding and evaluation by investors.

Market Trends and Recent Developments

Recent years have witnessed an uptick in structured product offerings, catering to the evolving demands of investors. Notably, structured products have gained traction among retail investors seeking to diversify their portfolios beyond traditional investment avenues. In response to this trend, financial institutions have launched a spectrum of structured products, offering diverse combinations of risk and return profiles.

However, it's essential to consider recent defaults and market challenges. In the past, structured products have occasionally faced criticism due to complexities that some investors may not fully comprehend. Moreover, market volatility and unforeseen macroeconomic events can impact structured product performance, as witnessed during the financial crisis of 2008.

Issuer Risk Management and Investor Considerations

Investors interested in structured products must meticulously evaluate issuer risk management practices. Robust risk management involves ensuring that the structured product's components and underlying assets align with the issuer's financial strength and capabilities. Thorough due diligence is crucial to assess the issuer's ability to meet obligations even in adverse market conditions.

For instance, when considering a Market Linked Debenture (MLD), investors should understand the product's underlying components and their potential impact on returns. In the case of a specific issuer, when an investor puts a certain amount into the structured product, a portion may be invested in the issuer's bonds, which offer higher coupons due to a lower credit rating. The remaining funds could be directed towards over-the-counter (OTC) call options, designed to optimize potential returns within a defined timeframe.

It's noteworthy that retail investors may not have direct access to the same options as issuers, which may impact the overall strategy's execution. Investors should be prepared to simulate similar strategies using available financial instruments, keeping in mind potential costs related to option rollovers and volatility fluctuations. In India, active trading is observed in only one and two-month forward options, which can influence strategy implementation.

Analyzing Incred's Managed Linked Debentures (MLD): A Comprehensive Assessment

Incred, boasting an A+ credit rating, introduces an intriguing investment avenue via Managed Linked Debentures (MLD). This innovative financial instrument intertwines a bond investment with NIFTY call options, promising an enhanced yield proposition. Let's delve into a meticulous analysis of this strategy:

Pros:

• Yield Optimization: Incred's MLD fuses a credit risky 10% fixed bond yield with NIFTY call options, strategically capitalizing on equity market potential.
• Risk Management: The strategic employment of a call spread mitigates premium costs linked to NIFTY call options, thereby minimizing overall risk premiums.
• Dual Profit Potential: If NIFTY call options perform favorably, investors can accrue gains from the fixed bond yield and profits stemming from options. As we see it currently the calls are struck between 22,250 and 25,350.

Cons:

• Potential Yield Constraint: While MLD enhances yields, returns could fall short of direct bond investments if NIFTY options perform below expectations.
• Market Volatility Exposure: Depending on NIFTY call options exposes investors to market fluctuations; an adverse market turn could dent overall returns.
• Credit Risk Awareness: Incred's A+ credit rating should be balanced against macroeconomic shifts that might influence the issuer's creditworthiness. We have to be aware that Incred carries a fairly large personal loan, and student loan books.

Analysis and Considerations:

Incred offers an initial 10% yield on its two-year bond. However, through MLD, the return translates to only about 6.6% CAGR for the fixed income part, achieved by redirecting Rs. 6 from the bond into NIFTY call options.

Utilizing the Black Scholes Merton model, implied volatility is gauged at approximately 18% for the lower strike call and 15% for the higher strike call assuming a smile in call options.

Evaluating the investment's viability involves scrutinizing India's growth prospects, its resilience amid global challenges, and the potential impact of factors like inflation, defaults, and debt levels.

Locked-in funds for two years influence the option's liquidity and, consequently, its implied volatility. Thus, actual option value might deviate from traditional market options. This is not a traditional call option like the LEAPs in the US that you can trade when you want. You are stuck with this for the next two years. Also you will make the gains only if NIFTY trades above the range at the end of the period.

While investors could potentially profit, it's crucial to recognize that the issuer and dealer also reap benefits from this MLD strategy.

In summary, Incred's Managed Linked Securities offer a hybrid approach that marries fixed bond yield with NIFTY option potential. While promising enhanced returns, this strategy involves inherent risks, spanning market volatility and issuer creditworthiness. Evaluating its feasibility necessitates a holistic evaluation encompassing macroeconomic trends, market volatility, and issuer credibility.

Conclusion: Navigating Structured Product Terrain

In conclusion, structured products present a compelling avenue for Indian investors seeking tailored investment solutions. These instruments blend risk management mechanisms with potential gains, catering to a spectrum of investor profiles. As the structured products market evolves, investors should remain diligent, conducting thorough due diligence, and comprehending the intricacies of the products they consider.

While structured products hold potential, recent defaults and market challenges underscore the importance of informed decision-making. Investors are encouraged to engage in comprehensive research, assess issuer credibility, and align structured product offerings with their financial goals and risk tolerance.