Investors continue to be hugely risk averse, and are looking for simplicity in their products, which in normal circumstances would make the market ripe for vanilla-style structured products, but confoundedly, current economic conditions have made the construction of vanilla products extremely difficult.
“As volatility has increased, plain vanilla structured products are expensive to construct and therefore unattractive with participation of only 30 per cent or so for the main indices,” says Jørgen Jakobsen, head of investment department at Nordea Bank S.A.. “With falling interest rates and rising volatility, better participation rates are not possible in the current market environment. The level of volatility expressed in the options is too expensive to operate in the old model, and it’s horrendously expensive if the investor takes no downside risk.”
The majority of the market is now auto-callables, which automatically mature prior to the scheduled maturity date if the underlying reference index hits a predetermined trigger level or ‘barrier’ on set dates, such as annually or quarterly. The underlying index will typically be an equity index, but it can also be linked to stocks, baskets of stocks and funds.
“Our clients are using a lot of auto-callables – and in this way, we are taking advantage of volatility,” says Mr Jakobsen. “Auto-callables have coupons of 10-12 per cent and are generally on main indices such as the Eurostox 50 and on Nordic indices such as OMX, Stockholm. Normally the client might be prepared to take a ‘buffer’ of the first 40-50 per cent of any fall in the underlying index – if it falls by less than the agreed barrier level, the investor still gets the capital back at maturity. Another attraction is that they are called automatically and so may be called after one year,” he explains.
“While general demand for structured products has levelled off, there has been strong demand for auto-callables which offer good upside and partial capital protection, and can therefore be seen to offer the best of both worlds,” adds Mr Jakobsen.
It is easy to see why these are popular. There has been a crop of kickout auto-calls paying over 8 per cent based on the FTSE. “There is no participation but investors are given the opportunity to generate a greater return than available elsewhere providing the FTSE stays the same or moves up,” says Alexandre Houpert, Société Générale’s head of listed products, UK and Northern Europe. “The protection is minus 50 per cent, an appealing risk level for investors. It would effectively mean the market would have to fall to 2,500 – its level in 1990 – for the capital not to be protected.
“Four months ago, when the markets were less volatile, the product would have paid 4 per cent but the greater the volatility, the better the coupon, and this is one way to profit from difficult markets,” says Mr Houpert.
Knowledgeable and experienced structured product users are becoming more inventive in their choice of underlying asset, however. Alex Robinson, structured products MD at EFG Financial Products, says while the FTSE is the most popular underlying, on occasion a client will want a product linked to a single stock – a recent request was Vodafone. A basket of three stocks or indices with outcome predicated on the worst performer is also common.
Phoenix auto-callables are becoming popular as they provide multiple opportunities for investors to earn the coupon. Under this structure, the coupon is payable if the underlying is above the trigger point on the observation date but if this is not the case, there will be a memory effect on the next coupon payment. This makes the Phoenix auto-callable suitable for investors who have a moderately positive view on the underlying asset as it potentially provides a stream of relatively high and above market coupons enhanced by the memory effect, coupled with the possibility of early redemption in a short period of time.
Volatility in the commodities markets can also be used to bump up coupons. In the summer, EFG structured a product on gold, silver and palladium, with a 60 per cent barrier, and paying 7.55 per cent semi-annually over five years. Such is the increased volatility in the market that this product has recently been put together again, but this time paying some 8 per cent semi-annually.
There are also products to protect against rising rates. Currency baskets can be designed to achieve this, such as a recent issue structured as a basket of currencies including the Norwegian and Swedish kroner and the Canadian and Singapore dollar versus sterling.
Some providers are looking to high growth economies to deliver upside. “What we see today is a decrease in appetite for equity risk and even with guaranteed protection, this risk aversion is a big theme,” says Josselin Lecuyer, head of structuring & asymmetric solutions Southern Europe at THEAM.
