Field notes

Three questions that come up regularly in conversations with investors, and that all bear on exactly what the zero-coupon bond guarantees.

1 · The guarantee is the issuer's, not the market's

A 100% capital-guaranteed product can lose 100%. Not because the underlying collapses (the ZC does protect against that risk), but because the issuer defaults. The zero-coupon bond removes the market risk of the underlying, but the investor bears the credit risk of the issuer.

The choice of issuer is therefore an investment decision in its own right. The investor has to be comfortable with the credit they are taking, and should not systematically pick the best bid: better terms compensate a higher risk. They should also diversify their issuer risk rather than concentrate their investments on a single house, unless they measure precisely the risk they are accepting.

The issuer is identified in the term sheet, together with the seniority of the debt issued. That is where it should be read: before investing, the investor must know who they are investing with and where they rank in the event of default. One and the same bank may also run several issuance programmes, carried by distinct legal entities, whose credits and rankings are not equivalent.

2 · The guarantee only holds at maturity

Outside the case of an issuer default, there is only one day on which the price of the zero-coupon bond is certain: the maturity date, where it is worth 100. Before that date its price varies with the residual maturity, the level of rates and the issuer's funding, and it can sit below the purchase price.

Take a 10-year capital-guaranteed product issued when rates were at 1%: its ZC cost 90.48. To isolate the rate effect, let us apply the shock immediately after issue, the maturity remaining 10 years. Here is what that rate leg is then worth.

Hence the exact wording to use in front of an investor: it is not a "capital-guaranteed" product, it is a product whose capital is guaranteed at maturity by the issuer. In between, the value shown on the statement can be below 100, and that holds even if the underlying has moved in the right direction. The reverse is true as well.

3 · The maturity has to be known

Third question, more technical: the formula requires a maturity, the T. Yet many products have no certain maturity: the autocall family, whose workings we will see in detail later in the programme, can be redeemed early if the conditions are met. Which zero-coupon bond do you set against an unknown maturity?

There is no simple answer. In these products the bank does not always buy a zero-coupon bond as such: it takes on the role the bond would play, but manages the rate risk dynamically. The expected duration then becomes a structuring and pricing parameter, on which each bank may take a different view. For the investor it changes nothing, the terms shown on the product are guaranteed by the issuer, whatever the way it hedges its own risks.