• Introduction
• Reverse floater
• Linked bonds
• Step up and Step down bonds
• Callable bonds

This section describes the main types of structured bonds currently on the Italian market. This is simply a short overview to provide assistance in understanding the characteristics of the products and their risk profiles. All the bonds illustrated feature elements of variable complexity in relation to determining the coupon owed to the subscriber.

Thus, specific attention should be placed on the coupon structure of the bond offered. It is also important to consider that structured bonds are issued mainly by banks, and thus, by virtue of Article 100, paragraph 1 (f) of the Consolidated Law on Finance, their offering to the public is not preceded by the publication of an information prospectus which must be preventatively sent to Consob. The only document investors may refer to upon subscription is the detailed fact sheet, drawn up in compliance with the instructions from the Bank of Italy.

Different to reverse convertibles, structured bonds can be admitted to official listing on the stock exchange. In this case issuers (even if they are not banks) are required to public a listing prospectus, which describes and provides suitable examples, of the characteristics of the product, potential yield in relation to possible future scenarios and specific aspects of risk connected to these scenarios.

It is important to note that not all structured bonds are listed on regulated markets, and where they are, liquidity levels are low. This could lead to difficulties if a subscriber intends to sell his securities in advance of maturity, as the prices may not reflect the real value, also because the investor could be forced to sell the bond to the same issuer, as it is the only buyer on the market.

These are fixed-rate bonds incorporating an Interest Rate Swap contract, which changes the fixed rate into a floating rate. By virtue of the contract, from the predetermined date, the subscriber has the obligation to pay the issuer a floating rate which usually coincides with, or is linked to, a market rate (for example, the Libor (London Interbank Offered Rate). From this moment, the coupon effectively received consists of the difference between the fixed rate of the security and the floating rate which the subscriber must pay to the issuer. The coupon varies based upon changes in the latter component which, in turn, is linked to the performance of market rates.

This type of bonds may seem very attractive, due to the payment of a fixed rate which is greater than the market rate. This advantage, however, is nothing more than the payment of a premium for the taking on of risk by the subscriber. The risk is represented by the future performance of market rates, and, specifically, the risk of these rates increasing. As a result of the mechanism of the difference between the fixed and floating rate, an increase in market rates would result in the subscriber receiving a coupon which is lower than the market coupon and, in extreme cases, the subscriber would receive no coupon if the floating rate is equal to or greater than the fixed rate initially set.

A decrease in the coupon would also lead to a decrease in the value of the bond’s principal. Therefore, should the subscriber sell the security prior to maturity, in addition to the problems linked to possible lack of liquidity or the absence of a secondary market, he would receive a lower price than that paid to purchase the bond and, thus, would be subject to a possibly significant loss.

However, the risk of loss of the invested principal following an unfavourable trend in interest rates is not a feature specific only to reverse floaters, but to all fixed rate bonds. It is specifically significant for longer term bonds.

These are bonds whose yield is linked to the performance of specific financial or real products, such as shares or baskets of shares (equity-linked), indices (index-linked), exchange rates (Forex-linked), commodities (commodities-linked), mutual investment funds (fund-linked) or others. The interest rate paid is generally lower than the market rate, while the reimbursement of the nominal value is guaranteed upon maturity. However, investors have the advantage of obtaining a premium, upon maturity, proportionate to the performance of the underlying financial product.

For example, by subscribing an index-linked bond, an investor effectively buys both a bond and a call option on the underlying index. In effect, this option is not free, and the issuer recovers its cost by paying an interest rate lower than the market rate.

The investor sustains the typical risk of the purchaser of an option: as time passes, the option looses value, and only if the underlying exceeds the strike price set upon issue will the investor receive a coupon flow.

A simpler version of the linked bond involves the payment of only the premium upon maturity, without payment of coupon interest. In this case, the premium also incorporates the coupon flow which is not paid over the life of the bond.

There are also linked bonds with guaranteed minimum yields, which reduce the risk of not receiving any coupon flow.

These products have recently appeared on the market. Though these bonds do not show a high level of financial innovation, their structure may, in any event be difficult for investors to understand.

In general, this type of bond is characterised by a predetermined coupon structure (not subject to uncertainties), which, however, varies over time. These issues are very similar to fixed rate securities, though with a specific feature of paying a variable coupon flows.

Specifically, step down bonds have coupons that decrease over time: the initial coupons are high, while the subsequent ones gradually decrease in value. Step up bonds have an inverse structure, where the final coupons are high, while the initial coupons are of lower value.

Lastly, it is worth mentioning callable bonds. These are fixed rate bonds with a clause that allow the issuer to reimburse the investor prior to maturity. Clearly, the issuer will be interested in reimbursing the bond when market rates are lower than the fixed rate. This product enables the issuer to more easily manage the risk linked to an unfavourable change in interest rates. The option that the issuer reserves must, evidently, have value for the investor. Thus, the investor should receive a rate greater than current market rates.