Index-linked bonds

Index-linked or structured bonds offer you a good way to benefit from the return of equity markets as in most cases index-linked bonds have principal protection.

  • Index-linked or structured bonds provide an alternative to direct investment in equities or equity funds.
  • Index-linked bonds usually have principal protection and are held until the redemption date. This means that you can earn almost as much as in equity markets but you do not risk losing the money you invested.
  • You do not have to pay any additional administration or account maintenance fees for holding index-linked bonds

The face value of principal-protected index-linked bonds is guaranteed. This means that on the redemption date when the investment ends you will get back the full face value of the bond.
There are two main types of principal-protected index-linked bonds:

  • 'Basic' type bonds
  • 'Extra' type bonds

Basic type bonds are right for you if you are a more cautious investor who likes to invest with a smaller risk premium and take less risk and accepts in return lower growth.

Investing in a Basic type bond with a face value of 1,000 euros at the subscription price of 102% of the face value costs you 1,020 euros. The only amount you are risking is the 2% that exceeds the 1,000 euros face value of the bond, which is called the risk premium, but you will get a smaller share of the profit than with an Extra type bond.

Extra type bonds are right for you if you want to see bigger growth and are ready to invest with a bigger risk premium and more risk.

Investing in an Extra type bond with a face value of 1,000 euros at the subscription price of 110% of the face value costs you 1,100 euros. The amount you are risking is the 10% that exceeds the 1,000 euros face value of the bond, which is called the risk premium, but you will get a significantly larger share of the profit than with a Basic type bond.
The subscription price may be higher than the face value of the index-linked bond at, say, 102%. The difference between the subscription price and the face value is the risk premium. This is the maximum amount that you can lose from your investment. If the value of the underlying asset falls, you will lose only the risk premium, or the amount that exceeds the face value of 100% of your investment.

If you invest your money in a principal-protected index-linked bond, you have three basic advantages:

  1. Principal protection or the guarantee that on the redemption date you will be paid back 100% of the face value of your index-linked bond;
  2. Options that let you benefit from the performance of the underlying asset. The more options there are in an index-linked bond, the larger your share in the growth of the value of the underlying asset will be. This is why it costs more to subscribe to an Extra type bond than to a Basic type bond but also why you can earn more from it;
  3. A secure bond which grows in value to 100% of the face value by the redemption date.
    An index-linked bond is tradable, meaning you can sell it before its redemption date. If you sell it before the redemption date, the amount you get for it will depend on its current price, shown by the fluctuating line on the graph.
    NB: There is no additional structuring fee payable by the investor as it is included in the subscription price.

A sample calculation for a Basic type principal-protected index-linked bond*
The principal of your investment is 1000 euros, the subscription price is 102% and your participation rate is 70%. Say the increase in the value of the underlying asset, which is calculated from the conditions that apply for the bond, is 40%.
The interest you will get on the redemption date is
€1,000 x 70% x 40% = €280
We will also return you the principal on the redemption date, meaning the total you will get is
€1,000 + €280 = €1,280
If the value of the underlying asset falls during the term of the bond, you will be paid the principal of 1,000 euros on the redemption date, but there will be no interest. Your loss in this case is the risk premium of 20 euros that you paid at the start.


A sample calculation for an Extra type principal-protected index-linked bond*
The principal of your investment is 1,000 euros, the subscription price is 110% and your participation rate is 170%. Say the increase in the value of the underlying asset, which is calculated from the conditions that apply for the bond, is 40%.
The interest you will get on the redemption date is
€1000 x 170% x 40% = €680
We will also return you the principal on the redemption date, meaning the total you will get is
€1000 + €680 = €1,680
If the value of the underlying asset falls during the term of the bond, you will be paid the principal of 1,000 euros on the redemption date, but there will be no interest. Your loss in this case is the risk premium of 100 euros that you paid at the start.

* The data used in the sample calculations are illustrative and do not represent the product's historical or expected performance. The examples illustrate principal-protected index-linked bonds; the face value of index-linked bonds without principal protection is not guaranteed.

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.

Underlying asset
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.

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.

Face value
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
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.

Risk premium
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.

Examples:

  • 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.

Subscription date
The date and time when the subscription period ends.

Subscription day
The day when an investor subscribes for a security by giving the order to purchase the security.

Subscription price
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.

Participation rate
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.

Examples:

  • 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%.

Redemption date
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.

 

  • The yield of an index-linked bond is always related to changes in the value of an underlying asset. Underlying assets may be an equity index, a currency, a commodity, an interest rate or any other asset that can be traded on the financial market.
  • You can see the yields of Nordea index-linked bonds here (in Estonian) 

     

 

An investment account provides more flexibility

  • Interest paid on bonds to private people is subject to income tax. However, you can postpone paying your tax if you buy bonds through an investment account.
  • You can read about the advantages of an investment account here (in Estonian).
  • You can read the explanations of the Estonian Tax and Customs Board HERE (in Estonian).