Paul Burgin looks at why market conditions require more exotic structured products to maintain protection and pay-offs.
Britain is a by-word for boring in the structured product world. In recent years, the simple capital-protected FTSE 100-linked product has reigned supreme, in contrast with the variety of multi-index, baskets and best-ofs sold widely on the Continent.
The unique shape of the UK market is caused by three main factors.
Since the Eurolife and precipice bond scandals, execution only sales have all but disappeared. That has left manufacturers two main routes – the IFA channel or bank networks. IFAs are highly regulated and highly cautious. Branch staff need simple products to sell over the counter, hence a huge surge in unregulated structured deposits in recent years. Strong competition and media attention keep the market in check.
Savings culture
The British savings culture is also less developed. Structured products are still satellite investments. They are an add-on to ordinary deposits, life wrapped, Isa and collective funds. In Europe, structured products are often fund-wrapped or tradeable. Britain’s buy-and-forget products have to be simple so that investors understand.
The UK had relatively limited exposure to Lehman-backed products. The incident did however place the emphasis on counterparties and understanding. Credit rating concerns limit the choice of protection providers and simultaneously increase the cost of protection. Even though that leaves them less money to generate a payoff, investors still want the simplicity of single index returns.
In 2008, uncapped call products with no maximum upside and capped call products accounted for over 40% of issues, according to SRPadviser.com. Most were linked to a single index, usually the FTSE 100.
They were twice as prevalent as digitals that promise a fixed payout if the index performs. And their structures were four times more common than the combined issuances of cliquets that accumulate performance along the way and reverse convertibles promising high income but a risk to capital.
Digitals
Last year, digitals took the lead as investors hunted for income. Market conditions slashed the number of uncapped calls by almost half. This year, SRPadviser.com reports digitals taking an even bigger lead as uncapped calls lose share.
Marc Chamberlain, executive director at Morgan Stanley, says: “Our culture of advice rather than the bancassurance model puts the stopper on exotic products. From a design point of view, it stifles payoff innovation. But is that bad? No, conservative products help investors dip into equity markets and the payoffs have been right for the time.”
Push to experiment
The pricing environment is pushing UK manufacturers and investors to experiment. There has been a move away from capital protected growth products, says Chamberlain.
Two years ago, a zero coupon bond, priced on prevailing forward rates and the CDS of the issuer, typically generated the equivalent of six to 6.5% pa with which to generate upside. Now a similar coupon might generate as low as 3% pa. “I have less to spend on the option and the option costs twice as much.” says Chamberlain.
Two current Morgan Stanley products illustrate the impact on the protection and participation elements. The firm’s 100% capital protected product offers an early exit in year three with an 18% return if the FTSE rises 15% or more. By switching to a capital at risk (CAR) structure with a 50% downside barrier, advisers can secure a payoff of 50% for their investors.
Morgan Stanley’s capital protected product is long running. Other providers such as Investec also ensure a permanent place for such offers in their ranges. But the cost of maintaining such products has altered considerably, says Chamberlain. Both Morgan Stanley and Investec protection is sourced internally, reducing the overall costs. Chamberlain says other manufacturers would struggle to look as good buying higher rated external AA+ rated protection at present.
Adrian Neave at Gilliat says the regulatory environment drives UK product design: “It is far more prescribed. The basis is whether the underlying client understands how the product works.”
A ‘flawed floater’ that pays the higher of three-month Libor or 2.5% looks simple to the adviser. Its fixed income nature may also have greater inbuilt appeal but is harder to explain than equity indices, thinks Neave. “The FTSE is soft and cuddly, made in London and the investors see it every day on the news. It is the easiest thing to buy and the asset class is in the right currency.”
Neave believes wealth manager and discretionary clients are open to more varied pay-offs and underlyings. There is interest in products that operate like synthetic zeroes, offering growth whilst the underlying index performs within a certain range over a given period, he says.
For the rest of the year, Neave expects product terms to remain around five to six years as low interest rates leave little room to purchase upside on shorter products. Income products will be thin on the ground too as low volatility pushes providers towards growth vehicles.
He expects more underlying indices to appear, saying: “Emerging markets are popular but hedging into Sterling is expensive and can negate upside protection.”
Pricing for single country indices for Korea, Taiwan, Hong Kong and Singapore looks reasonable for now, but investors are more likely to want emerging market basket products. Indices such as MSCI Emerging Markets can also be more easily hedged by ETFs. Neave says: “Advisers need to feel confident they understand that the more you narrow it down, the more risk you take.”
Robert Benson at SRPadviser.com expects more soft barrier and lower protection products. He says: “With interest rates low, the pricing drivers are pushing manufacturers in that direction.”
Classic FTSE five year fully protected products could look weaker in comparison, he adds.
Kick-out products are also likely to be less numerous, even if they help upside pricing. Increasing risk appetites mean investors are more willing to tie up their money.
