Certificates are a combination of fixed income financial instruments and derivatives. They were created as a result of customer demand for products that will simultaneously:
a) protect invested assets from loss (in whole or in part) and
b) enable participation in the capital market with the possibility of gain when the market is growing.
For example, by investing in deposits, T-bills or government bonds (and holding them until maturity), a predefined interest rate, or yield, is earned. Depending on the duration, this yield is most often around or below the inflation rate. However, investing in deposits, T-bills or government bonds offers a security role, the investment does not lose its nominal value, so investors "sleep peacefully".
On the other hand, investing in investment funds and equties assumes the possibility of a decline in value as well as the possibility of an increase in value => sometimes losses, but also gains, can be significant, so the fear of a loss (almost large) is a justified reason not to invest in funds and shares, just as high profits are justified reasons for investing in funds and shares.
Therefore, certificates as a combination of fixed income securities and derivatives simultaneously enable a) a security role (full or partial protection of the principal), b) exposure to risky and more volatile instruments (stock index, equties, commodities) under c) predefined conditions for d) a specific period.
Unlike equties, certificates do not give a share in the ownership of a company or the right to dividend payments. Unlike bonds, certificates do not offer the payment of a predetermined interest, but only specify in advance the conditions under which a certain action will be carried out.
1. Components of a certificates
Therefore, certificates are essentially fixed income financial instruments that give their holder the right to have a specific action performed by the issuer of the certificate under certain, pre-determined conditions. Certificates are also regularly considered structured financial instruments since they are usually tied to the value of another financial instrument or commodity (the so-called underlying instrument or underlying asset).
A certificate usually consists of two components:
- Fixed income financial instrument => protects part or all of the invested amount; for example, a bond
- derivative (most often an option) => provides additional return if predetermined conditions are met. The value of the option is linked to the performance of the underlying asset (e.g., stock index, equity, gold, etc.).
Certificate issuers are usually banks with verified credit ratings that are regularly rated by global rating agencies such as Standard & Poor’s, Fitch, Moody’s. Investors are advised to regularly check the credit rating of the issuer in whose certificates they intend to invest.
Why is the credit rating of the issuing bank important?
- A credit rating is an assessment of the credit risk of the issuer (bank), i.e. an assessment of their ability to repay the debt.
- Or, in the context of a certificate: a credit rating shows the ability of the issuing bank to fulfill its obligations when the certificate matures (for example, to pay 100 percent protection of the invested principal).
- Therefore, Banks with a verified credit rating are more reliable and able to fulfill their obligations in the future, i.e. the credit risk of such banks is lower than banks with a low or unverified credit rating.
2. Types of certificates
There are two basic types of certificates:
- unleveraged => geared towards medium- and long-term investments, less risky
- leveraged => geared towards shorter-term and riskier investments
Within unleveraged certificates, the two most common types are:
a) Certificates with 100% principal protection
- Certificates that allow participation in the positive return of the underlying asset in an (un)limited amount or certificates that pay coupons according to a predefined schedule, all depending on the performance of the underlying asset. Such certificates always last until a predefined maturity.
b) Certificates with conditional principal protection
- Express certificates that also have a predefined maturity, but can mature earlier if the value of the underlying asset increases above a predefined level. In this case, clients are paid the invested principal and a predefined yield (a fixed amount or a percentage of the increase in value). However, if the value of the underlying asset at maturity falls more than a predetermined percentage (e.g 40%), then the holder of the certificate is awarded the underlying asset (most often a single share) at the market value (therefore, minus the realized decline)..
3. Risks of investing in certificates
The most significant risks of investing in certificates are listed in the Key Product Information Document (KID):
- Credit risk, i.e. issuer risk => By investing in a certificate, the investor is exposed to the risk that the issuer will not be able to meet its obligations arising from the certificate, for example in the event of bankruptcy (inability to pay/over-indebtedness) or an administrative decision on rehabilitation measures (intervention risk). The entire invested capital may be lost.
- Market risk, i.e. the risk of changes in the price of the underlying asset => the impact of market risk depends on the type of certificate, and thus:
- In the case of certificates with 100% principal protection, the risk of changes in the price of the underlying asset is not significant. Why? Because if the price of the underlying asset falls at maturity, the investor still has the invested principal protected.
- However, with express certificates, the risk of changes in the price of the underlying asset is significant due to the existence of a barrier (e.g. 60%, 70% or 80%), so if the price of the underlying asset falls below the barrier on the maturity date, the investor in the certificate bears a significant unrealized loss (the certificate ceases to exist, and the investor receives a number of shares or money worth -40% (in the case of a barrier of 60%)
- Early redemption risk => Each certificate has a predefined term, so it is recommended for all investors to hold it until maturity. However, each certificate can be sold before maturity. The risk of early redemption is visible in the possibility that the market value of the certificate during its term may significantly deviate from the value of the invested principal, so the investor may suffer a loss in relation to the invested principal. Of course, if early redemption also implies an exit fee, then the potential loss is even greater.
In addition, the KID also lists a risk indicator that serves as a guideline for the level of risk compared to other products. It shows how likely it is that the certificate may lose money due to market movements or because the issuer of the certificate is unable to pay the investor. The certificate is classified on a scale from 1 to 7, with 1 representing lower risk products and 7 representing higher risk products.
4. Costs of investing in certificates
The description of costs is an integral part of the KID document and the Information on costs and fees document.
Product costs that may be charged to the investor:
- Entry fee => costs that are already included in the amount paid. For example, if we are talking about a deposit of EUR 15,000 in a certificate with 100% principal protection and a 5% entry fee, then the 5% entry fee does not reduce the protection of the principal, but it is protected at the level of EUR 15,000.
- Exit fee => costs that apply only in the case of selling the certificate before maturity. Exit costs do not apply if there is an early repayment (for example, with express certificates).
- Custody fee => cost of storing the certificate in the custody account (annual cost 10 – 20 bps, i.e. 0.1% – 0.2%).
- Brokerage fee => a cost that is calculated in the event of selling a certificate before its maturity (approx. 50 bps, i.e. 0.50% of the transaction value).
- AGIO => premium for purchasing a certificate => for example, the certificate from the above example is purchased for EUR 150 more with an "agio" of 1%, i.e. for EUR 15,150 (and then the principal of EUR 15,000 is still protected).
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