Investment is an important activity in managing wealth and achieving financial goals. For investors, understanding various investment instruments is very important. One of the most interesting investment instruments is synthetic bonds.
In this article, we will explore the meaning, benefits, and risks associated with synthetic bonds.
Definition of Synthetic Bonds
Synthetic bonds are financial instruments designed to mimic the characteristics of traditional bonds, but are not technically based on real debt. In creating a synthetic bond, the issuer creates a contract that allows the investor to obtain yields similar to traditional bonds, but without direct ownership of the underlying asset. Thus, synthetic bonds provide investors with exposure to price movements or the performance of certain assets without having to own these assets.
Types of Synthetic Bonds
There are several types of synthetic bonds commonly encountered in financial markets, including:
1. Synthetic collateralized debt obligations (CDOs): Synthetic CDOs are financial instruments that allow investors to gain exposure to securitized debt without actually purchasing the underlying debt portfolio.
2. Synthetic asset-backed securities (ABS): Synthetic ABS involves the use of financial derivatives to create instruments that mimic the performance of real asset-backed securities, such as mortgages or consumer credit.
3. Synthetic mortgage-backed securities (MBS): Synthetic MBS are financial instruments designed to mimic the characteristics of mortgage-backed securities without having to hold an actual mortgage portfolio.
Synthetic bonds are also called types of bonds that are made using derivative instruments such as options and futures. By using this derivative instrument, bondholders can minimize the risk associated with the price of the bond. In addition, synthetic bonds also have higher liquidity than ordinary bonds. In Indonesian, synthetic bonds are securities issued by companies or the government that have the status of issuers and are the object of a guarantee agreement. This securities is a debt instrument that has a maturity date and pays interest.
Synthetic bond is an instrument created to help minimize risk and reduce costs. Synthetic bonds can be made in various ways, one of which is by using derivatives. Synthetic bonds can provide positive results for investors, especially when compared to other instruments.
The advantage of this synthetic bond is mainly in the form of reduced risk and costs. In addition, synthetic bonds also provide other benefits, such as the ability to diversify the portfolio. The shortcoming of synthetic bonds is mainly in the form of high risk. In addition, synthetic bonds also require a relatively high cost.
A synthetic is a bond that is created through the use of financial techniques, such as derivatives, rather than through the purchase of government debt or corporate debt. Synthetic bonds can be used to create a variety of investment products, such as synthetic collateralized debt obligations (CDOs) and synthetic credit default swaps (CDSs).
Benefits of Synthetic Bonds
Investors are attracted to synthetic bonds because of the several benefits they offer, including:
1. Diversify the investment portfolio: Synthetic bonds provide an opportunity for investors to allocate their assets into different asset classes and increase the diversification of their portfolio.
2. Access to markets that were previously difficult to reach: Synthetic bonds can provide access to markets or assets that are difficult to reach directly for individual investors, such as the mortgage market or certain corporate bond markets.
3. Higher profit potential: Given the exposure it gives to the underlying asset, synthetic bonds can provide higher profit potential than direct investment in the asset.
One example of a synthetic bond is a total return swap (TRS), which is an agreement between two parties that exchanges the total return of a financial asset between them. It is designed to transfer credit risk from one party to another. The next example is the popular and widely discussed synthetic CDO (Collateralized Debt Obligation) in the film “The Big Short”. CDO is a synthetic bond created by using a credit default swap (CDS) as a financial instrument to transfer the credit risk of a group of financial assets (eg corporate bonds, bank loans or mortgages) to investors.
Investors who purchase synthetic CDO will receive interest payments from the CDO issuer, but must pay compensation in the event of a default on one of the financial assets that the CDO refers to. Next, there is something called a synthetic ETF (Exchange Traded Fund), which is a synthetic bond that is made using a swap or futures instrument as a financial instrument to replicate the performance of an index (for example the S&P 500, to the JCI) without having to buy all of the stocks that are its components. the index.
Investors who buy synthetic ETFs will receive dividend payments from the ETF issuer, but must pay management fees and the risk of swap or futures contracts. The last example is the synthetic GIC (Guaranteed Investment Contract), which is a synthetic bond made using money market instruments (eg Treasury bills, certificates of deposit, or securities) as financial instruments to guarantee interest and principal to investors. Investors who buy synthetic GIC will receive fixed interest payments from the GIC issuer, but must bear the risk of changes in the price of money market securities that are GIC’s guarantee.
Synthetic Bond Risk
Like any other financial instrument, synthetic bonds come with risks that need to be considered, including:
1. Credit risk and default: If the party issuing the synthetic bond is unable to meet payment obligations, the investor is at risk of experiencing financial loss.
2. Liquidity risk: Synthetic bonds may have a low level of liquidity, which means investors may find it difficult to sell or buy back the instrument at the desired price.
3. Regulatory change risk: Regulatory changes can affect the value and structure of synthetic bonds, thereby impacting investment performance.
Examples of Using Synthetic Bonds
Synthetic bonds have been used in various cases in the financial industry. For example, financial institutions can use synthetic bonds to mitigate risk or create investment products tailored to the specific needs of clients.
The implications of using synthetic bonds on a larger scale can also affect the global economy. Events related to synthetic bonds in the past, such as the global financial crisis in 2008, show the importance of a good understanding of these instruments and the potential risks that may arise.
Conclusion
Synthetic bonds are attractive investment instruments with unique characteristics. A good understanding of synthetic bonds is very important for investors who want to take advantage of them. By considering the benefits and risks associated, and through the right choice between synthetic bonds and traditional bonds, investors can make smart investment decisions that suit their financial goals.
