Alternative Investments: Structured Products

The main limitation on the basic zero-coupon strategy is that the working capital invested in the alpha generator is determined by the discount on the bond. Consequently, it is only a very small fraction of the total sum invested.

This places a limit on how much additional return the working capital can generate, over and above the yield on the bond. The basic structure provides protection against downside risk (the bond preserving capital) and offers some upside potential (the alpha generator).

There are other - leveraged - structures available for investors searching for higher returns (who are prepared to take on higher risk). These enhance the potential returns of the basic zero structure by using derivatives. When a derivative product is used to leverage the amount of working capital available from the bond, increasing its risk/return profile, the combined product is usually called a 'synthetic bond'. There are two main ways of increasing the amount of available working capital.

1. Using notes and interest rate swaps

The fund issues a promissory note or letter of credit to receive capital and simultaneously enters into a zero-coupon swap. Capital received is then invested in the alpha generator, leveraging the investor's total risk/return exposure

2. Using bond options

The small amount of working capital allowed by the zero-coupon bond is used to buy call or put options. Because an options contract allows you to gain exposure to the price behaviour of an asset for a smaller sum (the premium) than the asset value you are exposed to, working capital can be leveraged several times.

Using options can be particularly attractive because they allow both long and short positions, so the manager can generate returns from the alpha generator irrespective of market direction.

The selection of instruments used to enhance returns is governed by a range of factors, including the interest rate environment, taxation issues and the time horizon of the investor. Different instruments also offer differing degrees of flexibility to redeem the investment earlier than the maturity date.