Paul Burgin on using structured products in volatile times
Last Tuesday (15 June), markets went haywire. Contagion worries resurfaced, but not about Greek, Spain and the eurozone. This time it was BP and the increasing hostility it faces from US politicians over the Gulf oil spill.
With volatility high, Matthew Robinson, executive director of Morgan Stanley’s institutional equities division, had just one hour to price and issue a structured product note for Brewin Dolphin’s Birmingham office. The company had £5m in seed capital from investors, but was willing for the note to be offered to other investors.
Issued on Morgan Stanley’s own paper, the auto-callable five-year note is a defensive play. Soft protection is set at 50%, so the wealth manager’s clients would have to see the FTSE fall by half at maturity before they lose any money.
In the intervening years, the memory coupon is 12%, which builds up and is treated as capital gains. Such products are increasingly popular with investors looking to minimise their tax bills.
The Morgan Stanley product is designed for investors with a neutral to slightly negative outlook on the London stock market. It will kick out in the first year if the market remains positive. Thereafter, it will kick out if the market falls in increments of 5% each year.
Robinson says: “From initial request to turnaround, including hedging, it took one hour. These have become commodity products, but timing is essential to capture high volatility.”
Missing out on volatility as markets rallied later in the day would have cost an extra 50 basis points, he adds. There is also a strong appetite for Ucits structures which provide additional security for investors. On the same day, Morgan Stanley launched a new fund with full collateralisation on G7 corporate bonds. It too is auto-callable, kicking out each year if the FTSE 100 is in positive territory. In each year, it promises an 8.75% capital payout to a maximum maturity of six years.
Robinson says: “It compares well with performance on corporate bonds whilst mitigating counterparty risk with the collateralisation.” The fund raised £15m on its first day.
Secondary markets have been busy too. Morgan Stanley calculates that between 60% and 65% of its activity is in secondary markets, where investors sell out of or into existing issues.
The company hopes to introduce online trading in the near future. The arrival of third party pricing and dealing operators such as Matrix has already increased access, visibility and pricing, thinks Robinson.
Gilliat Financial Solutions is an independent provider and so has no secondary market.
Nonetheless, Adrian Neave says the market is following a similar pattern as it did in the spikes of the financial crisis. Back then, the main concern was counterparty risk. While good deals were to be had, investors fretted that the underlying banks promising to pay back capital would go bust.
He says: “Counterparty risk is still high on the list of priorities, but products are cash collateralised or backed by world class banks. As one only goes bust every 40 years, there is a question mark over the extent of counterparty risk.”
Investors have polarised into two camps. Those that remain worried will only accept backing from AAA or AA rated entities such as the EIB or World Bank. But such security is still expensive, meaning that investors have to accept less attractive payoffs. Others are looking beyond credit ratings, using CDS and other indicators, and have generally settled on a cut-off of an A rating on the S&P scale.
Neave says: “In the UK, there is still a distinction between state backed or rescued banks and the rest. Investors are comfortable using the likes of RBS.”
Feedback from his investment base suggests that the state effect is less of a comfort where US counterparty banks are concerned. He says: “One does not know what Obama and Co will do. Will their actions be politically expedient or make good business sense?”
European counterparties with exposure to Greek sovereign issues are also being looked at more closely. No investor has specifically asked to avoid those most at risk, such as French banks, but if they can get the same pricing elsewhere they will take the alternative option, says Neave.
In terms of payoffs, investors remain wedded to the FTSE. One year, investors could secure deals promising 10x leverage on the index. Leverage subsequently dropped back and only recently recovered to 7x.
For those wanting better deals, managers are willing to investigate ‘best ofs’ and baskets that include the UK index and others such as the S&P 500.
Discretionary buyers are also looking at interesting kick-outs, adds Neave. Dispersion trades between oil and gold have been popular. Wealth managers know that either oil prices will rise if the global economy picks up, or that gold prices will increase if the outlook deteriorates. But as no-one knows which is the most likely, managers are looking to profit from an ‘either/or’ scenario.
Paul Burgin is a freelance journalist
