Understanding Counterparty Risk in Structured Products: A Practical Guide for Advisers

Counterparty risk in structured products refers to the possibility that the issuer or obligor becomes insolvent and cannot meet its payment obligations. This risk directly affects both return and capital, making it a critical consideration for advisers and investors. Unlike market risk, which relates to underlying asset performance, counterparty risk is tied to the financial health of the issuing institution. If the issuer fails, even a product that performs well on its underlying index may deliver zero return.

For advisers, robust credit risk assessment is essential to ensure product suitability and protect clients from foreseeable harm. Regulatory frameworks increasingly emphasise this responsibility, as structured product returns rely entirely on issuer solvency. 

> A failure to assess counterparty risk adequately can lead to significant reputational and financial consequences.

Explore live metrics in Hilbert’s Counterparty Dataset, which includes CDS spreads, credit ratings, and balance sheet fundamentals and market indicators to help you make informed decisions.

What Is Counterparty Risk and Why It Matters

Counterparty (or credit) risk is the chance that the entity on the other side of an investment defaults on its obligations. In structured products, this risk is not peripheral - it is a primary determinant of outcomes. 

Coupons, capital repayment, and any conditional payoffs depend on the issuer’s ability to honour its commitments. Even if the underlying market performs favourably, an issuer default can result in total loss for the investor.

Traditional Measures of Creditworthiness

Credit ratings, assigned by independent agencies such as Moodys, S&P Global and Fitch Ratings summarise an issuer’s capacity and willingness to meet financial obligations. Ratings provide a widely recognised benchmark and allow advisers to compare issuers on a consistent scale. They also include outlooks and watchlists, which signal potential future changes.
However, ratings are not infallible. They often lag behind real-time market developments. A notable example was the emergency takeover of Credit Suisse by UBS in 2023. Despite mounting concerns in the market, ratings did not fully reflect deteriorating conditions. This delay illustrates why advisers should not rely solely on ratings; they need faster-moving indicators to capture emerging risks. 

Market-Based Measures: Credit Default Swaps (CDS)

Credit Default Swaps are tradable contracts that transfer credit risk from one party to another. The CDS spread, the cost of buying protection against default, reflects the market’s perception of an issuer’s creditworthiness. 

Wider spreads generally indicate higher perceived risk and increased protection costs. This is because CDS markets are highly responsive to new information, making them a timely barometer of credit conditions. 

For example, during periods of stress, CDS spreads can widen dramatically within hours, well before rating agencies issue formal downgrades. Advisers who monitor CDS spreads gain an early-warning system for potential credit deterioration.

Balance Sheet and Additional Market Indicators

To build a comprehensive view of counterparty risk, combine ratings and CDS data with balance sheet fundamentals and market indicators:

• Total Loss-Absorbing Capacity (TLAC): TLAC represents capital and debt buffers designed to absorb losses and reduce the need for taxpayer bailouts. Higher TLAC generally signals stronger resilience in a crisis. Learn more from https://www.bis.org.

• Non-Performing Loans (NPLs): NPLs as a percentage of assets indicate the quality of a bank’s loan book. Rising NPL ratios may point to stress in the economic cycle and potential pressure on profitability and capital adequacy.

> For more on NPLs visit European Banking Authority and its overview 

• Options-Implied Volatility: Implied volatility derived from listed options acts as a market “fear gauge.” Spikes in implied volatility often reflect heightened concern about an issuer’s prospects, even before fundamentals deteriorate.

> Learn more from https://www.investopedia.com/terms/i/iv.asp

A Practical Framework for Advisers

Here’s a step-by-step checklist to integrate counterparty risk into your recommendation process:

1. Identify Issuer Exposure: Map each product to its issuing entity and legal structure. It is important to note that different issuers have different structures, meaning not all issuing entities are guaranteed by the parent company. Reference product details as available in the KID documentation or at suppliers websites in tables.

2. Baseline Rating Review: Note long-term and short-term ratings, outlooks, and watchlists, from multiple agencies.

3. CDS Spread Analysis: Check current 5Y senior CDS spreads and recent trends (tightening or widening).

4. Fundamentals and Buffers: Review TLAC, capital ratios, liquidity metrics, and NPLs.

5. Market Signals: Scan options-implied volatility and equity performance for listed counterparties.

6. Document Suitability & Monitoring: Record rationale, sources, and thresholds for ongoing review. This documentation supports regulatory compliance and client transparency.

Key Takeaways

• No single metric is sufficient. Combine ratings, CDS spreads, balance sheet strength, and market indicators for a holistic view.
• Timeliness matters. Market-based measures like CDS and implied volatility can flag emerging risks faster than ratings alone.
• Process discipline improves client outcomes. A documented framework helps meet regulatory expectations and reduce foreseeable harm.

Conclusion & Next Steps

Counterparty risk is an unavoidable reality in finance, but it doesn’t have to be a barrier to success. When advisers understand this risk and apply a structured, multi-metric framework they transform it from a potential threat into a manageable factor. By combining credit ratings, CDS spreads, balance sheet indicators and market signals, advisers can confidently navigate issuer risk and make informed recommendations.

Structured products remain a powerful tool for delivering tailored outcomes; income, diversification, and capital growth when counterparty risk is properly assessed and monitored. With timely data and disciplined processes, advisers not only protect client portfolios but also unlock opportunities that might otherwise be overlooked due to a lack of understanding that puts less informed investors off.

The key is proactive engagement:

• Use our datasets to stay up to date with market developments.
• Apply due diligence checklists to ensure suitability.
• By embracing a comprehensive approach, advisers can turn complexity into clarity, safeguard client interests, and build trust through transparency. Counterparty risk isn’t just a challenge, it’s an opportunity to demonstrate expertise and deliver better outcomes.
  

FAQs

What is counterparty risk in structured products?

Counterparty risk is the chance that the issuer fails to meet coupon or principal payments. Because structured product outcomes depend on issuer solvency, credit risk assessment is central to product suitability.

Are credit ratings enough to assess counterparty risk? 

Ratings are a valuable baseline but can be slow to update. Combine them with CDS spreads, TLAC, NPL ratios, and options-implied volatility for a fuller picture. 

How often should advisers review issuer risk? 

Set a periodic cadence (e.g., monthly or quarterly) and event-driven triggers (rating changes, rapid CDS widening, spikes in implied volatility, material news). Use the datasets for monthly updates.

Compliance & Disclaimers

Structured products are complex and not suitable for everyone. Before making any investment decision you should read the Key Information Document (KID) and the brochure in full, so that you understand how the product works, the associated risks, the costs and the possible outcomes.

Hilbert does not provide investment or tax advice. If you are unsure whether an investment is right for you, you should seek professional financial advice. Hilbert’s products are available via a regulated platform.

Your capital is at risk and you may lose some or all of the money you invest. Early encashment may result in a return lower than the amount invested. Tax treatment depends on individual circumstances and may change.

This article has been adapted using AI tools for clarity, structure, and SEO optimisation. All technical content has been reviewed for accuracy and compliance.