Structured products back in the limelight

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.

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.”

Some investors are worried about inflation being imported, due for example to the increase in the price of oil, food and so on, and they are using commodities as an indirect hedge, he says.

Strong interest in emerging markets started a couple of years ago. “We issued a lot of equity and hybrid products linked to the view that emerging markets were going to outperform developed markets.” The two most popular single countries are China and India but Latin America is also starting to appeal to investors.

“For private banking and broad retail distribution, the dominant underlying asset class for structured products is still equities but commodities have increased a lot over the past two to three years. I think commodities structured products are here to stay – commodities are increasingly seen as another risk asset. Commodities, such as copper or coal, are also seen as a good way of getting exposure to Chinese economic growth for instance.”

Most recently, demand has been for agricultural or soft commodities as these are seen to offer more diversification benefits than other commodities such as base metals or energy, adds Mr Bernardi.

Alexandre Zimmermann, head of advisory and investment solutions at SG Hambros Bank, notes that in the past 12 months, but especially since the second half of last year, clients have had a very strong investment appetite for commodity, which comes from their strong conviction of the decoupling of the economic growth of emerging countries from the developed ones.

Structured products linked to commodities offer particular attractive terms as some of the commodities are trading in ‘backwardation’, as opposed to ‘contango’, meaning the forward prices of the commodity are trading below the spot prices.

“A way to optimise the exposure is through a note that offers a conditional protection on the downside plus the chance to outperform the selected underlying commodity, even when the performance of that commodity is close to zero or slightly negative,” he explains.

To gain exposure to a single commodity, as opposed to a basket of them, investors can use exchange traded notes, ETNs, which unlike ETFs or Ucits funds in general, do not need to comply with concentration limits regulations under Ucits.

Pproactive approach

In general, capital protected products are no longer suited to the current environment, because they have a long maturity, and offer only limited participation to the upside of the underlying and cannot be traded actively. But a proactive investment strategy is actually what is required today to play the direction trend, as the massive economic and structural changes across the world have major consequences on financial markets and can generate sudden trend reversals in equity, interest rate or foreign exchange.

“A lot of clients have realised that when investing in equity, commodity markets and to some extent in FX markets, you have to be proactive, you have to take the views on a very short time horizon, and you can no longer assume that because it’s a risky asset class it’s going to deliver high return over three to five years,” says Mr Zimmermann.

Clients are keener to look at direct investments, they take the full capital risk, but they know they can get out and take profit whenever they want, without having to wait until the maturity of the structured note to get their capital back plus part of the performance, he says.

“The trend is towards ‘back to basics’ and building portfolios of direct equities. We advise clients more and more on stockpicking rather than structuring notes, and a lot of clients have shown appetite for single manager hedge funds, when associated with weekly liquidity, especially equity long-short managers.”

As the cost of an indexation on inflation is very high, clients tend to use commodity rather than equity as underlying investments for a hedge against inflation. “Equity investments are probably less popular than six months ago, and they are not clients’ favourite underlyings or instruments to hedge themselves against the inflation risk.”

Counterparty risk

Counterparty risk was very much on investors’ minds two years ago. This led to the creation of fully colletaralised products, but today only a minority of distributors are still concerned about this risk, states Citi’s Mr Bernardi. “This means we don’t have to add in extra layers of protection and investors end up getting a better deal, as long as they are happy with Citi credit risk.”

For those who are still concerned, structured Ucits funds are a reassuring instrument, as it is highly regulated, carries virtually no counterparty risk, can be bought by everybody, and like other structured products, offers daily liquidity and high degree of transparency, which are critical for investors, he says. Citi offers some Ucits III funds that replicate traditional structured product pay offs in a fund wrapper, such as autocalls linked to the FTSE 100 index. In addition, the firm offers funds targeting absolute returns in commodities, FX and fixed income.

Especially since Lehman’s bankruptcy, the default risk is a major source of risk, says Mr Zimmermann at SG Hambros. Today, it is vital to monitor the variation of funding of the institutions used as collateral for structured notes, as this has an impact on the second market prices and performance. In the past few months, many financial institutions have raised their funding, which had a detrimental impact, sometimes substantial, on the secondary market notes recently issued by them and with a long remaining maturity.

“A positive performance of the underlying is offset by the impact of the funding, even if interest rates remain the same,” he says.

“That’s a type of mark to market risk that we are trying to monitor and to avoid, by selecting the right issuers, depending on the level of funding, and the risk of seeing that funding increased in the future.”

The UBS platform

According to its detractors, the creation in January last year of the Investment Products and Services unit, (IPS), by UBS Chief Executive Oswald Gruebel was part of a broader effort to reverse the massive outflow of wealthy clients’ funds, which the bank managed to do in the fourth quarter, and squeeze more money out of existing clients.

Mr Schiro, head of structured products at UBS Wealth Management, and previously in charge of the structured product team in the investment bank, rejects categorically any criticism that the investment bank may be using the private bank as a distribution channel through which to push its own structured products. “The wealth management side has always made sure that there was enough independence to pick and choose the structured products they felt were right for investors. That firewall is very important and was already in place before,” comments Mr Schiro.

The new structure has eliminated some distribution and marketing overlapping activities previously existing between the investment bank and the wealth management division in structured products. This was achieved by combining the teams of the investment bank, on the structured product side, that were largely focusing on UBS Wealth Management, and the team that was largely focused on structured products within the wealth management division.

“The main aim was to reduce some layers, to create new synergies and to get a more efficient set up,” he says.

Mr Schiro’s team is responsible for the buy side of structured products, but the issuance of products and risk management remains with the investment banks. “We do reach out to both our internal investment bank and external providers, to get the best of breed products for our clients. We also get proposals from our investment bank, but they go through our desk, before they go to clients.”

Of the total structured products that the wealth management division offers to its clients, the percentage issued by UBS investment banking can range between two extremes of 30-40 per cent to up to 80-90 per cent. That really depends on the competitiveness and quality of the ideas, says Mr Schiro.

Automating trades

Last September, Barclays Capital launched its new global electronic trading platform, Comet, in a bid to capture higher volumes of equity derivative and structured product trades.

“Over the past couple of years, the very standardised flow trades have, to a degree, gone back to basics, to quite simple structures. Therefore, for this business, we have built an online global platform which provides pricing and execution, as well as automised document generation, and we have recently rolled it out to many of our private banking, wealth management clients in the UK and Eu rope,” says Jane Balen Petersen, head of private banking coverage in Europe at Barclays Capital. The platform allows clients to price and execute bespoke flow structured products, across a wide range of underlyings, baskets and pay outs.

“This platform enhances the role of the private bankers, as it helps them to service the client more efficiently, being able for example to price up a few different structures without having to go back to his trading desk, and gives them a lot of flexibility to tailor make bespoke flow structured products, for a small notional size,” explains Ms Balen Petersen.