Alternative Investments: Structured Products

The zero strategy creates a defensive product with a large element of capital protection for investors who want to participate in otherwise high-risk, high-return asset classes.

With a zero coupon strategy, the investor's capital is split into two separate accounts. One account invests in zero coupon bonds and the other invests in a high-yielding asset class. This is to prevent any losses from the alpha generator impacting on the capital protected in the bond element. The ratio between the accounts depends on the discount on the zero-coupon bond and the level of protection required by the investor.

If, for example, the zero-coupon bond is sold at a discount of 6% and is set to mature in five years, the investor will get back get back 100% of the initial capital plus 6% providing that the bonds are held to maturity.

So, instead of investing 100% of the investor's capital in zero-coupon bonds, the manager will invest 94% of the capital, knowing that the 6% return will take the investment back up to the original capital investment after five years. This provides protection against capital loss. The remaining 6% capital can now be used to generate a higher total return.

Say, that 6% equated to £6,000 and the other £94,000 of the principal had been invested in zero-coupon bonds. The manager can then invest the £6,000 into high risk equities. If, after five years, these equities generate a 45% return, the £6,000 will have risen to £8,700.

Adding that to the £99,640 from the zero coupon bonds and you get a total of £108,340 - which is £2,340 more than the investor would have achieved purely through investing in zero coupon bonds. Should the equities fall in value, the investor's capital is preserved in the zero-coupon bonds.