Structured equity retail products provide a refuge

European investors have turned to structured retail equity products to protect their capital as stock markets flounder.

Structured equity retail products provide a fine example of necessity being the mother of invention. Because they enable investors to choose the precise level of risk they can tolerate, the persistence and depth of the slump in Europe’s equity markets has allowed the structured products market to show its true worth. It is one of the few retail sectors where issuance is growing. Merrill Lynch, which publishes a twice-yearly analysis of the market, estimates issuance of European structured products grew 8 per cent in the first half of 2002. The watchwords throughout the term were diversification and capital protection as investors showed themselves willing to compromise on performance in exchange for a guarantee that their capital was secure. This has made for a decisive move away from products based on single sector stocks and towards broader benchmarks. The technology, media and telecoms (TMT) stock baskets that were once so popular now appear infrequently. When they do, it is usually for the purpose of selling their volatility to generate income. Instead, sector indices, particularly STOXX sectors, are more commonly used in these baskets, providing a diversified underlying instrument for both growth and correlation/ income products. Also gaining in popularity are inflation-linked structures and global index baskets. Increased demand for such structures shows how much more realistic investor expectations are becoming; inflation-linked underlyings and global index baskets are exactly the kinds of safer but uninspiring investments that all but disappeared during the headiest years of the most recent stock market boom. The issuers’ response to an increasingly competitive marketplace has been to come up with ever more complex products. Coupon payment, for instance, is now a common feature of a variety of products that had traditionally been growth, rather than income offerings, such as the Cliquet structure (in which returns are locked in on a periodic basis) and CPPI (constant proportion portfolio insurance) structures. CPPI has played a crucial role in the structured equity market this year. CPPI provides capital protection by reducing equity exposure in declining markets and increasing it in rising markets, much like an option replication strategy. The low volatility that prevailed during most of the first half of this year meant CPPI products came of age, enabling issuers to offer a wide range of long-volatility (or growth) products without being obliged to sell volatility. The best example of the structure so far this year is the groundbreaking “Deposito Supersatisfaccion” E4bn fund-linked deal, which was brought to the market by Santander. Merrill Lynch analysts found that the average maturity of structured retail products has lengthened in line with the decline in appeal of the (typically) shorter-term reverse convertible structures. Spanish deal Total issuance of structured retail products in Europe in the first half of this year totalled E36.3bn, up 8 per cent compared with the same period last year. The increase is particularly impressive in light of falling equity markets and low interest rates. In case anybody needs reminding, the DJ Euro STOXX 50, S&P 500 and Nasdaq-100 registered losses over the semester of 18 per cent, 15 per cent and 35 per cent respectively. By country, Spain saw the highest growth in issuance with E5.6bn more structured retail products sold versus the same period last year. The rise was due primarily due to the E4bn issue by Santander Group. With this single deal, Spain became the second-largest market for retail structured products, accounting for one quarter of the European market. Deposito Supersatisfaccion is a capital protected deposit that addresses three elements of client demand: a high-yielding deposit, a diversified participation in equity markets by using a global basket of indices, and a fund of actively-managed funds protected by a CPPI structure. It is the first time a CPPI structure has been widely sold through a Spanish retail network. This three-year structure offers investors a three-way return deposit that pays a 3.125 per cent coupon in five months’ time as well as 100 per cent of the performance of a basket of Santander actively-managed funds at maturity, plus 15 per cent of the European performance of a basket of Euro STOXX 50, IBEX 35 and S&P 500, also at maturity. For Santander, the beauty of the structure is that all the underlying funds in the fund of funds are managed by Santander itself. So the deal increased the off-balance sheet figure of assets under management as well as the size of clients’ bank deposits. The product has had a tremendous impact in the market. Santander’s competitor, BBVA, swiftly launched a similar CPPI-based structure, labelled “Deposito BBVA Dinamico” and in June Morgan Stanley launched a CPPI-based deal linked to Morgan Stanley’s open-ended Sicav, the Global Brand fund and the IBEX-35 index. Italy consolidated its overall lead in structured products, increasing its issuance by E1bn during the term to E12bn. Italian investors have increasingly taken refuge in capital protected products in light of weak equity markets and low returns on fixed-income products. In Italy, capital protected products are offered by insurers and banks. Insurers capitalised on the appetite for these structures by introducing new features to their index-linked policies. These products, traditionally wrapped in the form of a structured bond, now frequently offer additional payoff features such as Swing options or the worst-of-lookback Cliquet. Under this structure, the return at any point is determined as the worst performing stock or index in the basket. In addition, the lookback feature selects the worst return over each Cliquet period. The Italian Post Office was the prominent issuer in the market, confirming its leadership in this type of innovation. Italian banks also took advantage of the upswing in demand for capital protected issues. During the first six months of this year, Merrill Lynch reckons around 40 per cent of banks’ issues were CPPI products, stealing market share from the standard zero-coupon-plus-call structure. Running alongside the trend for capital protection in Italy has been a return to familiar structures. The real surprise in the insurance market, for instance, has been the dramatic rebound of traditional capital protected products over the unit-linked and index-linked sectors. Traditional products are those hedged by the insurance companies themselves, forming part of their asset-liability management. Having accounted for just 20 per cent of the insurance market in 2000, traditional products upped their market share to 40 per cent during the period. This more conservative approach to investment was behind the decline in issuance of structured equity products in the UK, where many investors simply exited the equity market altogether. A decline in issuance of E2.4bn was recorded for the first half of 2002 – the sharpest fall seen in any European country. France and Switzerland also saw issuance volumes fall as investors in those countries pulled in their horns. Negative media coverage of lease products in the Netherlands has adversely impacted the country’s Click Fund (or capital guaranteed) market. Some providers have withdrawn their marketing campaign for this type of products altogether. Lease products are those where the investor pays a monthly premium for the right to buy a basket of shares or indices at maturity. Protected structures The overwhelming trend in the first six months of 2002 has been the growth in issuance of capital protected products. A full 97 per cent of Italian issues and 98 per cent of Spanish issues were structured with 100 per cent or more of their capital protected. Capital protected products accounted for 93 per cent of total European issuance. The most dramatic year-on-year change has been recorded in Scandinavia. Whereas only 29 per cent of this region’s issuance was capital guaranteed in the six months ending in June 2001, 100 per cent of issuance for the six months ending June 2002 was capital protected. In terms of underlyings, the DJ Euro STOXX 50 maintained its dominance as the most popular single index, with more than one in five issues using this as an index. The DJ Euro STOXX 50 was also a common component of global index baskets, which typically consist of the DJ Euro STOXX 50, the S&P 500 and the Nikkei 225. Products that combine the DJ Euro STOXX 50 with an inflation-linked component are gaining favour in Portugal, Italy and, to a lesser degree, Spain. Correlation products, whose price is affected by the correlation between assets of the same class, are also gaining in popularity, witnessed by the rise in stock basket structures from 9.7 per cent to 21.3 per cent. Individually capped Cliquets on stock baskets, in which each stock is locally capped but not locally floored, are also selling well. Belgium is leading innovation in such products. One example is BBL’s Selectis Digital Bonus, an eight-year income generating structure paying large annual coupons which can be scaled down if a downwards barrier is breached. However, the product offers the possibility of winning back the coupons depending on whether the barrier is breached in the final year. Also in Belgium AGF has devised a structure in which investors are able to choose between a distribution and capitalisation profile. In France, the appeal of correlation products is reflected in the popularity of Podium structures – a fully capital guaranteed structure in which annual coupons are paid at maturity, but the coupon depends on the number of underlyings within the basket that have had a positive performance. The UK’s Barclays has come up with an interesting twist on the correlation theme with its Swing products. These structures pay at maturity the sum of annual coupons that are the absolute value of the minimum movement – positive or negative – among a basket of stocks. What’s new about the latest range of correlation products is that many employ short-volatility structures, whereas most correlation products until now have been volatility-neutral. Short-volatility structures are still popular, but the product that was once the mainstay of this market – reverse convertibles – has all but disappeared as European investors seek products with capital protection. Because reverse convertibles typically have shorter maturities, their disappearance has led to an increase in the average product maturity to nearly 56 months from 52 months during the first six months of 2001. The only exception to this rule is the UK, where for historic reasons reverse convertible structures continue to sell well. Leveraged-downside reverse convertible structures are nothing new to UK investors, but there has been some interesting innovation on the theme. Premier, for instance, has introduced a bolt-on feature to reverse convertibles in which soft protection is achieved by the sale of an ATM strike put with a down-and-in barrier at typically 70 per cent to 80 per cent of the initial market level. Under the structure, the option is activated if it breaches a barrier set below the initial level of the underlying. By adding an extra up-and-out barrier at 140 per cent of the initial market level the product boasts a lock-in feature. If the underlying rises above a certain level, the option knocks out and is no longer valid. If the market rises by 40 per cent at any point there is no chance of any capital erosion at maturity. In other words, the put option knocks out. Volatility Volatility, which began the year at close to its historical average declined through much of the first six months of 2002 only to rise sharply in June as equity markets plummeted. During the bulk of the term, when volatility declined in line with rising confidence in equities, interest rates drifted higher. The combination of higher rates and lower volatility lent itself to growth products through increased participation rates. The gradual decline in equity indices also served to increase their dividend yield, which further reduced the price of a call option and increased participation. But when markets entered a sharp decline in the latter half of May, volatility started a steep increase, swap rates fell, anticipating further monetary loosening, and participation rates consequently fell. In the past, low interest rates and high volatilities presented an opportunity for income (or short-volatility) products. This time around there has been little appetite for reverse convertibles and the like. Overriding any technical support for income products has been the slump in investor confidence. Arik Reiss has served as an equity derivatives analyst in the Global Equity-Linked Research team at Merrill Lynch since March 2000. Based in London, this team is part of the Merrill Lynch Global Securities Research and Economics Group. He is responsible for research and strategy related to futures, options, structured products, exchange traded funds and indexation.