Income structured products are market-linked investments that are designed to pay an enhanced level of income well above the risk-free rate and ahead of inflation.
Income can be fixed and is generally paid annually or monthly depending on the term of the plan. Alternatively, income can be dependent on the performance of the underlying asset.
Income products can be capital protected or capital-at-risk. For capital protected products, original capital will be returned in full regardless of performance of the underlying asset, subject to counterparty risk. Capital-at-risk products incorporate a conditional capital protection feature so that capital will be returned in full provided the underlying asset has not fallen below a certain level (‘the barrier level’). This barrier level can be measured at any point during the term of the investment (an American barrier) or only at maturity (a European barrier).
Income products are structured through the use of a zero coupon bond and a derivative package of options.
A zero coupon bond is a corporate bond that pays no coupon during the term of the bond, but returns a fixed amount at maturity (the original capital investment).
An option is the right (not the obligation) to buy (‘call’) or sell (‘put’) a set quantity of the underlying asset at a given price on a specified date in the future.
Selling a put option increases the amount of money available to invest in the options required to deliver the potential income payments. It is also the sale of this put option that introduces any risk to initial capital if the underlying asset were to fall a significant amount.
The knock-in put option sold would 'knock-in', or become active, if the underlying asset has fallen below its barrier level prior to its expiration, giving the buyer of the option the right to sell the underlying asset back to the counterparty at its Opening Level price.
Other options are purchased to provide either the fixed payout or the income payout if the underlying is above a predetermined level.
£10,000 is invested into a six year income product, paying a fixed 6% annually, with 50% European barrier based on the FTSE 100 with an Opening Level of 6,000. Client receives an income of £600 gross per annum. Capital is returned in full at maturity providing the Final Level of the underlying asset is not more than 50% below its Opening Level.
- If, for example, the Final Level of the FTSE 100 was 2,700, which is 55% below its Opening Level, the client would receive back £4,500 of their original capital. This is in addition to the income they would have had throughout the term.
- If the Final Level of the FTSE 100 was 5,400, which is 10% below its Opening Level, the client would receive back their original £10,000 capital. This is in addition to the income they would have had throughout the term.