Defensive structures for turbulent market phases

The product class of capital protection notes has held its own in the Swiss market for over three decades, starting with a structured product with capital protection issued in 1991. Since then, capital protection notes have offered unique features that have made them popular with risk-averse investors.

The way capital protection notes work is quickly explained. At maturity, these products are characterized by capital protection on the one hand and participation in the performance of the underlying asset on the other. The repayment at the end of the term is determined depending on the final fixing of the underlying: if the final fixing of the underlying is above the strike price, an amount equal to the defined participation in the performance of the underlying is paid out in addition to the capital protection. The amount of the participation in the performance can be disproportionately low or high or at a ratio of 1:1. In the case of under-proportional participation (e.g. 50 percent), investors participate to a reduced extent in the positive performance of the underlying. Disproportionately low participation is often accepted in favor of a higher level of capital protection. If the final fixing is at or below the strike price, the capital protection is repaid. This capital protection amount is typically between 90 and 100 percent of the nominal value.

With regard to the attractiveness of capital protection notes, it is clear that their design can offer particular advantages in certain market phases. At their core, these products consist of two components: a zero bond (or zero-coupon bond) and an option component (usually a call option). The zero-coupon bond is issued below its nominal value and ensures repayment at maturity in the amount of the capital protection.

The interest rate environment has a decisive influence on the conditions of capital protection notes. It directly influences how expensive the capital protection is in the present and how much capital is available for the option component. The interest rate environment can therefore have a positive influence on the amount of participation or capital protection.

Against this backdrop, the current geopolitical situation gains additional relevance. The closure of the Strait of Hormuz as a result of the conflict in the Middle East has significantly driven up oil prices. As a result, inflation expectations have also risen, which in turn has led to higher yields on the bond market. It is precisely this combination of rising interest rates and increased volatility that plays into the hands of the mechanics of capital protection notes described above and could make them even more attractive.

Further information on capital protection notes can be found in our know-how article at this link.

Barrier Reverse Convertibles (BRCs) are among the most popular structured products on the Swiss market. One advantage of BRCs is their flexibility, as they can be adapted to different investor profiles. Investors seeking higher returns can benefit from more attractive coupons by selecting the appropriate product parameters - with a corresponding increase in risk. At the same time, a BRC is also suitable for more risk-conscious investors who want to forego part of the coupon in favor of greater conditional capital protection (in the form of the barrier).

A key factor here is the choice of barrier. If the barrier is set higher, more attractive coupon payments can be achieved, but the risk of the barrier being touched and the associated losses increases significantly. On the other hand, lower barriers offer better protection against falls in the price of the underlying assets. In return, investors generally have to accept a somewhat lower coupon.

Another equally important factor in the decision-making process is the term of the BRC. BRCs with a longer term entail a higher risk if the barrier is continuously monitored, as the underlying has the opportunity to touch the barrier over a longer period of time. So if you want to take less risk in turbulent times, you should not consider too long a term.

The choice and number of underlyings also play an important role. Basically, the more underlyings a BRC is based on, the higher the risk, as the barrier observation is based on the weakest security, the so-called worst-of. Each additional underlying increases the probability that at least one of them could break through the barrier. The volatility of the individual securities is also relevant: Strongly fluctuating underlyings increase the probability of the barrier being breached. The correlation between the underlyings also plays a decisive role in BRCs with several underlyings (so-called multi BRCs). If the securities have a low correlation with each other, they tend to move independently of each other, which increases the probability that at least one of them will perform negatively.

Further information on barrier reverse convertibles can be found in our know-how article at this link.

In an environment characterized by geopolitical tensions, rising inflation expectations and increased volatility, defensive strategies are coming to the fore. Capital protection notes offer downside protection with simultaneous participation in rising markets. Barrier reverse convertibles, on the other hand, can be made more defensive through a targeted choice of parameters such as lower barriers, shorter maturities and less volatile underlyings. Structured products can therefore be a valuable addition for risk-conscious investors, especially in turbulent market phases.

Despite their defensive characteristics, investors should not ignore the issuer risk of structured products. The repayment of the invested amount or any coupons depends on the creditworthiness of the issuer. If the issuer becomes insolvent, investors may suffer losses, regardless of the performance of the underlying assets.

It should also be noted that structured products may be traded below their theoretical value during the secondary market phase. This can be the case particularly in phases of increased market volatility. A premature sale of such products could therefore lead to losses. Investors should therefore be aware of their individual risk tolerance and the planned holding period before investing in order to avoid unexpected losses.