Bonus Certificates: How they work
Bonus certificates are suitable for investors who expect prices to trend sideways, fall or rise slightly over a certain period of time. A bonus certificate generally relates to an underlying asset, usually a share or an index, and can be superior to a direct investment in certain scenarios. If the price of an underlying asset moves within a predetermined price range over the term, the exercise price (bonus level) is paid out to the holder of the bonus certificate. The upper end of the price range is limited by the strike price. This also determines the redemption amount, taking into account the conversion ratio specified in the product terms and conditions. The barrier is located at the lower end of the range. If the price falls below this barrier during the term, the entitlement to the strike price expires and the investor receives the underlying securities on maturity or a cash settlement.
How Bonus Certificates work
Bonus certificates fall into the category of investment products and can be an interesting instrument for investors who expect prices to trend sideways, fall slightly or rise slightly in order to optimise their returns in such market phases. In order to understand how a bonus certificate works, the two features already mentioned are particularly important, namely the strike price and the barrier. The strike price is usually higher than the current price of the underlying asset when the product is issued or fixed. The barrier is below the current price. If the price of the underlying moves within the corridor between the strike price and barrier over the term, a bonus certificate takes full effect. In such a scenario, the investor receives the strike price at the end of the term, which is calculated by multiplying the strike price by the conversion ratio.
If the price falls below the barrier during the term, the entitlement to the exercise price expires. The investor then receives either shares of the underlying security on maturity or a cash settlement. The repayment in this (negative) scenario is therefore based on the level of the underlying (the share or index) at the time of the final fixing. Depending on how the underlying performs after the barrier is reached, there may be significant losses.
Scenarios
To understand when a bonus certificate is beneficial for investors, it is useful to compare this product with a direct investment in the underlying asset as an example. This comparison is also shown graphically in the illustration below. Three scenarios are considered at the end of the term.
In scenario 1, the underlying loses a lot of value and falls below the barrier during the term. As a result, the claim to the exercise price expires. Once the barrier has been reached, the product behaves in a similar way to a direct investment in the underlying. This means that (significant) losses can also be made if prices fall by the end of the term. It should also be noted that the price of a bonus certificate may include a premium. The reason for this is the payout profile in the spread between the strike price and the barrier. If the barrier is reached, this premium is removed from the price of the certificate, which can therefore increase the loss compared to a direct investment. However, if the price of the underlying recovers by the end of the term, such an interim loss can also be recovered (in whole or in part).
In scenario 2, the price of the underlying moves between the barrier and the strike price over the entire term. This is where the bonus certificate fully demonstrates its strengths over a direct investment in the underlying. In this case, the investor receives the strike price at the end of the term. The return that can be achieved with the bonus certificate generally exceeds the return on a direct investment.
In scenario 3, the price of the underlying rises sharply and is above the strike price at the time of the final fixing. In such a case, the investor either receives physical delivery of the underlying asset at maturity or a cash settlement. Investors therefore have the opportunity to participate in such an upward movement. However, it should be noted that a bonus certificate may include the aforementioned premium. In such a case, the investor pays a price for a bonus certificate that exceeds the price of a direct investment in the underlying security. The return achievable via the certificate (in this comparison) in the event of a sharp rise in prices is therefore lower.
Structure
Two components are of crucial importance when structuring bonus certificates. Firstly, a call option with a strike price of CHF 0.00 is required. This option gives the holder the right to buy the underlying at CHF 0.00 at the end of the term. Put simply, this option replicates the performance of the underlying asset; the holder of the option is not entitled to any rights from the underlying asset (e.g. the share), such as dividends.
In order to achieve the payout profile between the barrier and the strike price, a further option component, a “down-and-out put”, is required. The down-and-out put has a strike at the level of the strike price and a barrier at the level of the barrier of the bonus certificate. In general, a put option gives the holder the opportunity (the right) to sell an underlying asset at a certain price (strike) at a certain point in the future. If the price of the underlying asset is below the strike at the end of the term, the holder of the option can sell the underlying asset at a higher price than it is trading at on the market. This makes it possible to profit from falling prices of the underlying asset. However, the term “down-and-out” indicates that this is a special type of put option that expires worthless (“out”) if the price falls too sharply (“down”).
The payout profile of a bonus certificate is made possible by the combination of the aforementioned (option) components. If prices are at or above the barrier during the term and below the strike at maturity, the down-and-out put has a value that compensates for the difference between the price of the underlying and the strike price and thus enables the strike price to be paid. In particular, the costs of purchasing the down-and-out put are decisive for the premium that may be included in the price of the product. If the barrier is reached, the down-and-out put expires worthless and only the call option with an exercise price of CHF 0.00 remains. Payment of the strike price is then no longer possible. If the price is above the strike at maturity, the down-and-out put is worthless. Thus, in this area too, only the call option mentioned is decisive for the payout profile.
The price of a bonus certificate is calculated from the prices of the individual option components during the term. The pricing of options is subject to a number of factors. In addition to the price of the underlying asset, the volatility (fluctuation range) of the underlying asset, the remaining duration of the option and the interest rate level are particularly decisive. The price of the bonus certificate is therefore also subject to the influence of these factors during the term period.
Product variants
In addition to the classic bonus certificate, there are other types of bonus certificates.
Bonus certificates with a cap
Bonus certificates with a cap, for example, are widely used. They are equipped with a cap that limits participation in rising prices of the underlying asset above the cap to a maximum amount. The disadvantage of limited participation in rising prices may be offset by advantageous product conditions such as a lower product price or a lower barrier.
Reverse bonus certificates with cap
Another variant is reverse bonus certificates with a cap. These are products that enable reverse participation, in which the product profits from falling prices of the underlying asset, taking into account a cap.
Multi Bonus Certificate
Multi Bonus Certificates are based on not just one but several underlyings (multi-asset). The underlying market expectation should be that none of the underlying assets will touch or break through the barrier during the term.
The product is characterized by participation in the performance of the underlyings. If no barrier event occurs during the term, an amount equal to the nominal value multiplied by the average performance of the underlyings is paid out at the time of redemption. However, the conditional minimum repayment is equal to the bonus amount.
In the event of a barrier event, no further bonus amount is paid out and either the specified number of the underlying with the worst performance (worst-of) is delivered or a cash settlement is paid, which corresponds to the performance of the underlying on expiry.
Advantages & Risks
Advantages (bonus certificates, bonus certificates with cap)
- Positive returns even if the price of the underlying asset falls, provided the barrier is not breached during the entire term
- Attractive returns even in sideways, slightly upwards and even slightly downwards markets
- Possible yield advantage over direct investment in the underlying asset in the event of sideways or slightly falling prices of the underlying asset
- Full and unlimited participation in rising markets beyond the strike price (not for bonus certificates with a cap)
- Manageable investment horizon
Risks (bonus certificates, bonus certificates with cap)
- Significant losses are possible if the barrier is breached (risk of total loss)
- If the barrier is breached, losses may be higher than for the underlying asset compared to a direct investment
- Products are exposed to market influences during the term, such as the performance of the underlying and volatility
- No capital protection
- Issuer risk (issuer or guarantor cannot fulfill its obligations under the product)
- In the case of bonus certificates with a cap, the maximum achievable profit is limited
- No dividend payments, no current income
- Currency risk for underlyings in foreign currencies