When it comes to certificates, many market participants immediately think of highly speculative financial products. However, individual derivatives also offer risk-averse investors attractive return opportunities.
With certificates, investors can participate in the performance of an underlying asset without purchasing it directly. Stocks, indices or various raw materials can serve as the underlying value. Contrary to popular belief, certificates are not only suitable for risk-taking investors and speculators, but also for security-oriented investors.
Certificates for Conservatives
The collective term “certificates” encompasses very different product types, which carry different risks depending on the type. This also includes risky investment products such as warrants, turbo certificates and knock-out certificates, which are only suitable for very experienced traders. Investors who trade with such leveraged products are at increased risk of suffering a total loss.
However, not all derivatives are associated with such high risks. Among the multitude of different certificates, there are also suitable products for conservative investors. If the risk of investing directly in stocks is too high, guarantee certificates, express certificates and equity bonds are an attractive alternative.
Stock bond
By purchasing a reverse convertible bond, the investor participates in the price development of an underlying asset. This is usually a share or a share index. The reverse bond also pays the investor a fixed interest rate, which is not subject to any further conditions. The main difference with conventional bonds is that the repayment at the end of the term depends on the price of the underlying asset. If the price of the share on the repayment date is above a predetermined price threshold, the so-called strike price, the investor receives the full repayment of the nominal value plus the coupon. However, if the price is lower at the end of the term, the investor receives the value of the reverse convertible bond in the form of shares of the underlying asset. The subscription ratio at which the investor receives the shares is agreed before the certificate is issued. The investor receives the specified coupon regardless of price development and repayment. The reverse bond thus combines the typical features of bonds and stocks in one product.
Example of a stock bond
An investor invests 5,000 euros in equity bonds from company X, which have a term of one year.
Term: 1 year
Coupon: 7% pa
Base price: 200.00 euros
Share price: 206.00 euros
Subscription ratio: 1:5
Nominal value: 1,000 euros
On the due date, the investor can always expect a coupon of seven percent, i.e. exactly 350 euros for a 5,000 euro investment. There are now two options for the entire redemption of the certificate:
1. The price of the share rises above 200.00 euros at the end of the term and the investor gets 100 percent of his investment back. The investor would receive a total of 5,350 euros.
2. The price of the share falls to 195 euros and the investor receives the company share booked into his portfolio at the agreed subscription ratio. In this case, the investor would receive 25 shares for a total price of 4,875 euros. In this case, too, the coupon payment received brings the investor a total of 5,225 euros.
Warranty certificates
As with all derivatives, the guarantee certificate also refers to an underlying asset. Typically, this underlying asset is a share, a stock index or any commodity. If the price of the underlying asset increases, the buyer of the guarantee certificate receives a predetermined share of the profit, which is determined by the agreed participation rate. The participation rate can vary from certificate to certificate.
If the price of the underlying increases by ten percent and the participation rate is 85 percent, the investor makes a profit of 8.5 percent. However, if the price of the underlying asset falls, the buyer receives the nominal value of his investment at the end of the term. In this negative case, the investor only loses the previously paid issuing premium for the certificate.
Example of a guarantee certificate
An investor invests 5,000 euros in a guarantee certificate that has a term of four years.
Base price: 130.00 euros
Repayment on maturity: 100%
Participation rate: 80%
At the end of the term after four years, two scenarios can arise:
1. The price of the share is 180 euros at the end of the term and the investor receives 80 percent of the price profit achieved. If the price increases from 130 euros to 180 euros, the underlying value increases by 38.46 percent, of which the investor receives a share equal to his participation rate of 80 percent. Accordingly, the investor makes a profit of 30.76 percent and would receive an amount of 6,538 euros after 4 years.
2. The price of the share is 120 euros at the end of the term and the investor receives back the 5,000 euros he invested.
Express certificates
Express certificates have fixed terms of several years. Every year the repayment of the certificate is checked on a specific date. If the price of the underlying asset on the key date is above or at the same level as on the issue date, the investor receives repayment of the capital invested plus a coupon. However, if the price of the underlying asset on the key date is below the level on the issue date, the Express Certificate will run for another year. If the underlying value of the certificate does not reach the level of the issue date on any key date, there will be no early repayment of the capital invested.
Thanks to a built-in risk buffer, there is still the possibility of repayment of the capital invested at the regular end of the term – but without a coupon. The risk buffer guarantees the repayment of the capital if the underlying asset has not fallen below a certain safety threshold on the last reference date. Depending on the certificate, this security threshold can be up to 20 percent below the price of the underlying asset when it is issued. However, if this threshold is fallen below on the last reference date of the certificate, the investor realizes the complete loss in the price of the underlying asset.
Express certificate example
An investor invests 5,000 euros in an express certificate, which has a term of four years. There is a chance of early repayment depending on the price development of the underlying asset. If the underlying value is above the respective repayment threshold on a valuation day, the express certificate will be repaid at a fixed amount.
Basic price: 100 euros
Security barrier: 80 euros
1st key date: base price over 100 -> repayment of 110 euros -> investor receives 5,500 euros
2nd key date: base price over 100 -> repayment of 115 euros -> investor receives 5,750 euros
3rd key date: base price over 100 -> repayment of 120 euros -> investor receives 6,000 euros
4th key date: base price over 100 -> repayment of 125 euros -> investor receives 6,250 euros
If the base price of the share is still above the safety barrier of 80 euros at the end of the term, the investor will receive his investment back at 5,000 euros. Transaction costs and taxes have not been taken into account for the returns shown in the examples.
General risks
Certificates always involve an issuer risk because they are certificates Bonds acts that promise future performance. If the issuer becomes insolvent, the investor could face total loss in the worst case scenario. For this reason, the creditworthiness of the issuer should be of fundamental interest to investors.
Pierre Bonnet / editorial team finanzen.net