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Structured Products: Then and Now

Christopher Brown, CompareStructuredProducts.com - 02/09/2015

“Those who do not remember the past are condemned to repeat it.” – George Santayana

The quality of structured products has undoubtedly improved in the last fifteen years. While the terms have improved, the product literature has also become clearer in its explanation of the risks and rewards. While there is always room for improvement, it is worth looking more closely at structured products now compared to the past. For those who are sceptical about these investments, it shows a reason to reconsider these products as a useful addition to portfolios.

Over the years, Lowes, as an Independent Financial Adviser considering all product types for investor portfolios, has been analysing the structured products market, and has always stood up for the good value products whilst warning against the poor ones. It is often necessary to look back on the past to really appreciate how far we’ve come, and a look back on the precipice bonds that we warned against over a decade ago highlights the advances that have been made in the market since then.

A brief history of the market

In the early 2000s, we published a leaflet warning investors and journalists about the high risk of the latest breed of stockmarket-linked income bonds, which offered a high level of income and (apparently) a high level of capital security. These products are now commonly – and quite justifiably in many cases – referred to as ‘precipice bonds’. This is because although there is usually a safety margin built in, once this is breached the fall in the capital value can be quite rapid.

The document, “The Truth Behind Those High Yield Stock Market Bonds”, produced by the Lowes investment team detailed a number of examples of products that were available at the time, and warned investors against them as the attraction of a high level of income coupled with the capital protection they offered could potentially be misleading to those who perhaps did not understand them fully.

This lead Lowes to maintain a comprehensive and up-to-date database of all such products on the company website – www.Lowes.co.uk– highlighting which products we felt investors should steer clear of. This service is now published under CompareStructuredProducts.com, a site dedicated to structured product offers traditionally distributed through Independent Financial Advisers, where products are rated as ‘Preferred’ or not.

One example of the ‘precipice bonds’ that we warned against on the original service was the Canada Life High Income Bond Series 3. This bond, linked to the Nasdaq, offered a headline rate of 10.5% gross interest per year over a three year period, with investors’ capital protected unless the final index level was more than 20% below the starting level. The trade-off here was that the capital loss downside was actually 3.33% for every 1% the index fell by more than 20%. We at Lowes felt this was a dangerous possibility and as it was, the Nasdaq fell, the barrier was breached, and the eventual overall loss on this particular bond was a staggering 75.43%. Investors who were lured in by high headline rates without appreciating the risks may have quite rightly felt deceived by these products, and unexpectedly suffered significant capital losses for it.

As a consequence of much of the ensuing negative publicity, pressure from the FSA and industry as a whole, providers began issuing better value contracts by 2004. Since then, the quality of structured products has improved even more.

Structured Products Now

There are now a range of high-quality products available. The Walker Crips Annual Growth Plan 35 (Kick-Out) is, in our opinion, a good example of one of the better products on the market. It is an auto-call (‘kick-out’) product, which means that it can mature early if a pre-set conditions are met on one of the defined anniversaries. Investors can get a potential 8.5% per annum gain on their investment, which will be payable from any year (from the second anniversary onwards) where the FTSE 100 Index closes equal to or above its starting level. Therefore, this product has the potential to mature early where there have been just small increases in the market, allowing for investors to bypass the full six year term and consolidate their returns, potentially for reinvestment if they choose to.

Furthermore, the capital protection on offer here, and in many other products on the retail market, is generally significantly better. This product features a capital protection barrier of 50%, observed only on the final day of the investment, meaning that the index would have to fall below half of its starting value at the end of the term to produce a loss. The downside is also less penal, like many other structured products currently on offer. Any loss will be equal to the percentage fall in the Index, rather than the accelerated downsides that were inherent in many of the precipice bonds of the past.

The Walker Crips plan is just one example of a broad range of good value, high quality products that are currently available. One thing that the structured products market collectively should not be accused of is a failure to improve and learn from the mistakes of previous market participants. Indeed, while there are always going to be better products to others, and providers should continue to adapt to ensure they are appropriately meeting investors’ needs, a look at the structured products available today should be enough assurance that the spectre of precipice bonds should be considered as a thing of the past.