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Structured Products: A lifeboat in rough seas?

Ian Lowes - 06/07/2016

The uncertainty around the impact of the Brexit vote means that volatility will continue to be a significant function of markets for the foreseeable future. Conversations with the EU are most optimistically forecast to take up to two years for a conclusion to be reached, but with seven years of negotiation predicted by an EU Council Chief.

Following the vote for Britain to exit the EU, UK equities bore the brunt of heavy selling pressure as the market opened, falling by 8.7% to its lowest point, but has since recouped such losses to now trade back above the 6,500 level. The promised cut in corporation tax by George Osborne is a commitment to keep businesses in the UK, while volatility has been seen in the shares of domestically focused UK businesses with the FTSE 250 trading lower than it was prior to the vote. The level of dividend cover across British companies has fallen to just below 1x, the lowest since the end of the last recession in 2009.

One the reasons that structured products are dismissed by some investors is that they do not participate in dividends, but as with all types of investing the total returns figures should be considered. While investors do not actually receive the dividends from the underlying index, structured products are built to offer attractive total returns that can outstrip the price return of the underlying measurement. One way they do this is geared participation, where a multiple, say 5 times, of the rise in the underlying index is offered.

Holding structured products during volatile times is valuable because of their in-built barriers, observed during or at the end of term, which typically protect original investment capital against markets falls of 40% or 50%. This means they can complement other investments, such as active funds that aim to significantly outperform the market. Structured products can often deliver returns in a low or no growth market environment. For example, the terms of an auto-call often require the market level on a relevant anniversary to just be the same as or higher than the initial level for maturity to occur.

In the case of defensive products, these can make positive returns in slightly falling markets, usually around 10% down. Some products will only require the underlying measurement to be higher than 90% of the initial level for the defined returns to be achieved, while others have a reducing reference level for maturity to occur. A current example is the Focus FTSE Defensive Kick Out Plan July 2016, an auto-call contract that will mature on its second anniversary if the FTSE 100 is at or above 100% of the level measured at commencement of the Plan, but this maturity trigger falls to 95% on the third anniversary and by a further 5% each subsequent year, down to 80% on the sixth anniversary. If the FTSE is above the relevant trigger point on any anniversary, the maturity proceeds will be 7.7% for each year the investment ran. If the positive maturity does not arise, the investment is designed to return original investment capital at the end of six years, unless the FTSE is below 60% of the initial index level, in which case a loss will arise in line with the fall over the term.

The two primary risks that need to be considered when buying a structured product are market risk and counterparty risk. The market risk is the conditions required for positive returns to be achieved, while the counterparty risk depends upon the solvency of the institution backing the loan underlying a structured product. The Focus plan above has Credit Suisse as counterparty. Some plans transfer the risk of a catastrophic loss arising from the failure of the issuing bank to alternative banks through a collateralisation program. If one of the alternative financial institutions fails only a portion of the investment is likely to give rise to a loss.

The beauty of structured products is the flexibility in design, range of measurements and terms available, which means that products can be selected for their individual merits and based on market expectations. In the broadest sense, if you’re bullish you could go for a growth plan that requires the market to be higher and will give you geared participation on that growth. If you think markets will be choppy, an auto-call with multiple maturity opportunities over a 5, 6 or, even a ten year term, the coupons rolling up the longer it takes to mature, and usually only requiring the market to be at the same level or higher, would be an option worth considering. If you’re bearish, defensive plans that can still make returns in slightly falling market conditions could be considered. Of course, each product needs to be considered on its own individual merits and all the potential outcomes understood, but using a combination of such investments alongside a more traditional portfolio can be very rewarding, with the outcomes of the structures being predictable in all market conditions.