After a couple of very tough years, structured products are gradually emerging from the shadows, as interest in these flexible investment instruments has finally picked up again.
The Lehman Brothers collapse in September 2008 almost brought to a halt the whole industry. Investors and distributors realised investment banks providing these products could go bankrupt and became aware of the real meaning of counterparty risk. The issuer’s credit quality became high on everyone’s agenda.
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Last year, the huge level of market uncertainty and fears related to the sovereign debt crisis generally dampened interest in risk assets, which are the preferred underlying of these structures. But over the past six months, as investors’ confidence returns, structured products have been increasingly in demand. One of their more appreciated characteristics is that they can be tailored to the investor’s specific risk profile and investment view.
“On average, private clients still have a very high allocation to cash, and there is now need to put that cash more to work and invest back into risk assets, such as equities or commodities,” says Vittorio Schiro, head of structured products at UBS Wealth Management. “But clients may hesitate to go straight into risk assets and structured products can overcome part of that hesitation, through capital protection instruments or through some yield enhancement structures, such as reverse convertibles.”
Full capital protection has proved very expensive of late, due to low interest rates and high volatility, although this has now reduced. With investors reluctant to be locked into long-duration products, the compromise is to use structures that put some of the capital at risk and offer, for example, 90 per cent protection.
“Clients are happy to get some form of protection, as long as that gives them some exposure to the underlying markets,” says Mr Schiro.
Also very popular are yield enhancement, reverse convertibles type of structures, where investors take some exposure to the downside, and limited participation to the upside, but are compensated with a higher coupon. These income generating products are especially attractive in the current low interest environment.
The two extremes
Structured products sit between the two extremes of placing money in cash or equity: capital protection notes are closer to cash, and the yield enhancement or reverse convertible structures are closer to an equity investment. “Leaving out the leveraged instruments, most structured products are more defensive than a plain investment into a risk asset, and we can respond to the client risk preference and investment needs by structuring a product that best meets their market expectations,” continues Mr Schiro.
“The whole industry is still far away from the peak, but it is definitely a very solid recovery. The simple, mainstream structures were the first to recover, and we are definitely focusing on this trend. Clients are very cautious when innovation comes with increased complexity.”
Development in the structured product space is at a crossroads, states Sophie Barnett, vice president at Morgan Stanley. “Over the past year or so, with volatility swinging between extreme highs and then trending back down again, product development was very much driven by the pricing environment, it was about payout innovation and trying to capture market opportunities, and we saw that across Europe in all markets,” says Ms Barnett.
Investment themes
With volatility now reducing, investors are starting to think more about thematic investments, and innovation can go back towards the underlying side. One key theme is inflation. “Investors are worried about high inflation eroding the value of their portfolio and they are looking at ways to hedge their portfolios against it,” explains Ms Barnett. “Because pure inflation products, linked to inflation indices are expensive at the moment, additional equity or FX (foreign exchange) conditions can be introduced to try and boost those inflation linked returns.”
For example, a note linked to Eurozone inflation can be structured introducing an equity linked redemption condition, instead of doing it in capital protected format. This would potentially double the return linked to inflation to two times inflation paid as income each year. At maturity, investors will get the capital back as long as the underlying, such as the Euro Stoxx 50 index, has not breached a certain barrier, which may be 50 per cent or more. FX conditions can also be employed, where capital redemption is based on the performance of a currency against another.
Another very popular way to play the inflation theme is through commodities, which can be an effective combined play on inflation and emerging markets, explains Jean-Luc Bernardi, Emea head of financial engineering at Citi. “Over the past 6 to 12 months, in particular, the two big themes that really stick out the most are emerging markets, and the one related to it, commodities.”
