Structured securities are hybrid securities that integrate the features of a debt instruments and a derivative. The motive behind creating a structured security is to lower the borrowing costs as well as to appeal to an audience such as institutional investors who would otherwise have some restrictions on what kind of securities they can invest in.
One of the most common derivative instruments used in creating structured notes is a swap. For example, we can combine a coupon paying bond with an equity swap in such a way that the structured note so created pays a coupon periodically; however, the coupon payments are linked to an equity index. In an equity swap, two parties agree to exchange a set of future cash flows periodically for s specified period of time. Once leg of the equity swap is pegged to a floating rate such as LIBOR or is set as a fixed rate. In this case this is the coupon payment on the bond. The cash flows on the other leg are linked to the returns from a stock or a stock index. The leg linked to the stock or the stock index is referred to as the equity leg of the swap.
Such a structured note will appeal to institutional investors who have restrictions on investing in equity or derivative securities. However, since this structured note is essentially a debt security they will be able to avoid the restrictions and invest in these notes.
There are various types of structured notes. Some of these are discussed below:
Step-up notes: This are bonds in whose case the rate of interest gradually moves up till the date of maturity for a specified period and for the later years, is usually paid at a higher rate than the initial years.
Inverse floaters: These are the bonds for which the coupon rate is inversely linked to a reference rate such as LIBOR. When the reference rate increases, the coupon rate decreases and vice verse.
Deleveraged floaters: These are the securities for which the coupon rate is computed as (k x reference rate) + quoted margin where k is a fraction (less than 1).
Dual-indexed floaters-rates: These are bonds for which the coupon rate is based on the difference between two reference rates. The coupon formula will be coupon rate = (R1 – R2) + quoted margin, where R1 and R2 are two pre-specified reference rates.
Range notes: Range notes are another interesting type of structured notes. The coupon rate is linked to a reference rate. As long as the reference rate is within a pre-specified range, the coupon will be equal to the reference rate plus a quoted margin. However, if the reference rate is outside the range, coupon paid will be zero.
Index amortizing notes: The index amortizing notes have a fixed coupon rate. However, the payment of principal is linked to a reference rate. Based on the level of reference rate, some principal amount is prepaid to the investor.