Principal-protected index-linked bonds
An index-linked bond or structured bond is a hybrid security that combines several components, usually a zero-coupon bond and an option. Combining an option with a bond changes its risk/reward ratio and gives the investor a secure way of earning more than with regular bonds. Investing in index-linked bonds is also a way to invest in asset classes that would be too risky to invest in directly.
The yield of an index-linked bond is related to changes in the value of its underlying asset, which is an index. If the value of the underlying asset increases, the investor earns income. If the value of the underlying asset falls, the investor earns no income. When the principal-protected index-linked bond reaches maturity, the investor is paid back the principal, which is the face value of the index-linked bond.
The underlying asset, or index, of an index-linked bond may be any financial asset. The most common types are equity indices and equity baskets, exchange rates and commodities.
A market index or a pre-defined set of securities, which determines the price and yield of an index-linked bond through its price changes. The term is used for any financial instruments, such as equities, futures, commodities, currencies or indices, that are used as a basis for the price of a derivative security like an option.
A derivative security that gives the buyer the right to buy or sell a financial instrument at an agreed price on a specific date. There is no obligation to make the transaction defined in the option and if the price of the underlying asset is not attractive it may be better not to make the transaction.
The pre-defined value of a security, which remains constant, unlike its market price. Whereas the market value of a security varies over time and expresses its current value, the face value, also called the 'nominal value' or 'principal' does not change.
When a principal-protected index-linked bond is redeemed, its holder is paid the face value plus accrued interest.
Principal protection means that Nordea guarantees the investor that at maturity the face value of a security will be maintained. The face value of the principal-protected bond is paid out to the investor at maturity whether the value of the underlying asset of the index-linked bond has risen or fallen. If there is a positive return, the investor will also paid interest.
Principal protection applies to a bond only on its redemption date. If the investor wants to sell the bond before the redemption date, this can be done at the market price, which may be higher or lower than its face value.
The part of the subscription price of an index-linked bond that exceeds its face value. If the subscription price of a bond is 102%, the risk premium is 2%; if the subscription price is 110%, the risk premium is 10%.
A risk premium is a fee paid by the investor for boosting the return of an index and there is no guarantee that it will be paid back. If the yield calculated for an index-linked bond is greater than the risk premium, the investor profits from the investment. However, if the yield calculated for an index-linked bond is smaller than the risk premium, the investor's loss is the difference between the premium and the yield.
- If the subscription price is 102% with a risk premium of 2%, and the yield is 5%, then the investor's profit is 5%-2% = 3%;
- If the subscription price is 110% with a risk premium of 10%, and the yield is 7%, then the investor's profit is 7%-10% = -3%, meaning the investor makes a loss;
- If the subscription price is 105% with a risk premium of 5%, and the yield is 0%, then the investor loses the whole of the risk premium.
The date and time when the subscription period ends.
The day when an investor subscribes for a security by giving the order to purchase the security.
The price at which the investor can subscribe for a security.
The subscription price of an index-linked bond may change throughout the subscription period, so a different price may be offered for subscription orders that are given at different times. The part of the subscription price of an index-linked bond that exceeds 100% is called the risk premium.
The participation rate is expressed as a percentage and it shows how much of the increased value of the underlying asset of an index-linked bond is allocated as profit to the investor.
- If the participation rate is 70% and the index gains 40%, then the profit allocated to the investor is 40% x 70% = 28%;
- If the participation rate is 180% and the index gains 40%, then the profit allocated to the investor is 40% x 180% = 72%.
The date when a bond becomes redeemable, or the maturity date of a bond, which is when Nordea as the issuer of the bond pays back the principal and the yield to the investor.