Structuring solutions to market volatility

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.

“What we are trying to do is to focus on countries where there is (worthwhile) GDP growth such as emerging markets and risk control the underlying index before structuring and protecting the investment against the downside.” Controlling the volatility on the underlying is achieved using a proprietary index, though some use similar indices devised by S&P.

“We feel there is less risk aversion when we choose a geographical zone that is benefitting from GDP growth and this is easy to understand. We are fond of diversified exposure and opening access to different classes of assets to give more alpha, while in comparison GDP growth in the developed countries is slow.”

ALTERNATIVE SOLUTIONS

One area structured products could be useful is in the emerging market currencies space, which have come under a lot of pressure in the last few months. Structured product might be a good means of achieving exposure to Asian currencies which investors may feel will rise.

Products based on hedge fund lacked liquidity during the crises, but several providers are using a platform of managed accounts with absolute return exposures and good liquidity as the basis for products.

“The role we’ve taken is to give access to hedge funds and alternatives solutions to clients who want more security, so we wrap these assets into a capital structure,” says Eric Bell, head of structured products at Man Group. “There is muted appetite for risk-on products, but investors are also looking for assets that can generate returns. This product allows investors with a minimum of $30,000 (E22,000)-$50,000 to dip their toes into hedge funds.”

Man Group, which merged with the alternatives and long only hedge fund manager GLG at the back end of last year, tends to send out three or four products a year and raised $0.5bn in assets in capital guaranteed products in the first two quarters. Demand dropped off in 2008, and volumes are not back to volumes like 2006-7, but Mr Bell says the performance of these products has held up well against traditional assets. A key consideration is that while the guarantees come at a cost, the products otherwise carry the same fees are going direct. The structuring fee is 1 per cent of NAV and the capital guarantee is 20-40 basis points.

The UK’s first structured product investment platform, SPGO, went live in September, making structured products more transparent for advisers to compare, invest in and monitor, instead of having to transact on a case by case basis. “The SPGO platform not only helps with the initial product selection but crucially with the ongoing monitoring of the product post purchase,” says Ben Murison, SPGO co-founder.

“For example, if you want to know if a capital at risk barrier has been hit or a product issuer has been downgraded, SPGO will automatically tell you. The network will also allow products to be bought and sold in the burgeoning secondary market.” The Royal Bank of Scotland, Morgan Stanley, Société Générale, Nomura, Citigroup, Jubilee Financial Products and Gilliat Financial Solutions have made products available via the platform.

COMPLEXITIES

However, Graham Bentley, head of investment marketing at Skandia, warns that under Mifid II, structured products will be complex products, so even an execution only platform will need to make an appraisal process that is appropriate for clients. “Since Lehman in 2008, it has been clear that the FSA expects products to be constructed as a result of customer research, not by boffins creating a product and hoping they can encourage clients to buy it,” he says. “This development won’t kill the market but there will have to be lots more effort to get investors to understand.”

Risk aversion remains entrenched across Europe, exacerbated by the performance of equity-based products launched before the summer which suffered from the downturn in August. In Germany, for example, investors have been extremely cautious and conservative and the segment of capital-protected products increased to 62.0 per cent of the entire open interest of investment products, according to data from DDV-Deutscher Derivate Verband 2011.

“In terms of capital protection there has also been high demand for target-vol products,” says Dominik Auricht, expert in structured investment products at HypoVereinsbank onemarkets, the German arm of the UniCredit Bank. HVB was the first issuer to introduce risk-controlled target-vol-mechanisms with capital-protected structures in 2009.

“This rules-based investment mechanism based on stock market volatility has been successfully applied to multiple indices, like Euro Stoxx 50, S&P Bric, DivDAX, Cross Commodity Long/Short index or Oil Index Plus. Three main objectives are thus achieved – the strategy is at least as good as or even outperforms the basic underlying, while simultaneously achieving better conditions for capital-protected structures by reducing the price of the option component, and access to new markets that are typically not accessible.”

Due to the extreme low interest rate situation and high volatilities in the equity markets, investors have also been looking at products offering regular and attractive coupons, like step-up notes, or at products without complete capital-protection, like credit-linked notes or barrier reverse convertibles, says Mr Auricht.

Barrier reverse convertibles, mainly on blue chips, have been in particularly high demand, and are seen as a good way to encourage investors back into the equity market. They offer simple, clear pay-off and attractive coupons which will be paid in any event. “Additionally, they have short-term maturities, usually one year, and investors focus on stocks they know very well,” adds Mr Auricht.

“After the latest market turbulences, this kind of product can offer coupons up to 7 or 8 per cent pa, way above the riskless interest rate. Investors even prefer single-digit coupons, when the safety threshold is comfortable enough – on average we are talking about 50-70 per cent. Should the safety threshold be hit, the customer gets the shares delivered instead of a nominal reimbursement and so has the opportunity that the share price may rise again.”