Taking control of counterparty risk

Part of the appeal of structured products is their flexibility – the ability to choose the balance of risk and reward that is right for an individual investor. Some buyers are more focused on safety features, like capital protection or soft protection. Others are more focused on ‘high performance’, such as leveraged upside or bonus features.

But as well as the features of the product and the advertised payout, investors should also consider how the payout is provided - who is responsible for paying that return. In particular, when products are advertised as “capital protected”, how secure is that protection, and who provides it?

Until recently, this issue of counterparty risk received scant attention – most investors were confident that their money was safe and were less focused on the details. However, since the collapse of Lehman Brothers, counterparty risk has moved to the headlines. If investors can select their preferred balance of capital protection and return potential, surely they should also have more choice over the level of counterparty risk they take on?

This need for more choice has driven a new wave of innovation and transparency from product providers.

Where is the credit risk?

Before investors and advisors can compare different structured products, they need to be aware where the counterparty risk lies and how to evaluate it. The key is to understand what happens to the initial investment. Most “capital protected” structured products work in a similar way: the provider of a structured product uses the initial investment to do two things.

Firstly, they buy some assets, such as bonds, to secure investors’ capital. Secondly, they buy a derivative contract to give a growth or income return. So there are two different kinds of counterparty risk: exposure to the issuer of the assets, and exposure to the derivative provider. In most cases, these are the same counterparty. But increasingly, with many of the new products on the market, this is not the case.

So how does an investor compare the counterparty risk of different products? One way is to look at the credit ratings of the parties involved. Although credit ratings have their limitations, they are at least an independent assessment of a company’s financial strength. Whilst the limited number of rating designations available (from AAA to D) make it easy for investors to compare different issuers, are credit ratings on their own too simplistic an indicator? For example, how would an investor choose between two AA rated issuers? Investors can supplement ratings with their own research – looking at the company’s recent financial results and any published investment research – to come up with a view on the financial strength of a company.

Another measure that can be used is the “credit spread”, which shows the premium at which the counterparty’s debt trades over a “risk-free” rate. Although credit spreads allow a more granular comparison of issuers than credit ratings, they can be quite deceptive: credit spreads are based almost entirely on market perception and the liquidity of the underlying swaps. As a result, they are subject to short-term fluctuations. They are probably best reviewed in conjunction with the credit rating.

Multiple choice

Historically, most investors have bought structured products in the form of notes or certificates issued by single financial institutions. These are essentially a promise by the institution to pay the advertised return at maturity. An advantage is that the credit risk of these products is transparent – the notes are as good as the institution that issues them. However, many investors are now looking for lower or more diversified credit risk and, in particular, for products where assets are held as collateral. These assets can be used to repay investors if, for some reason, the product provider cannot pay the advertised payout.

Product providers have had to respond to this demand and innovate. For example, in the UK retail market, some providers have recently launched structured products backed by UK government bonds.

We also saw the first products where both the capital repayment element of the product and the derivative element were collateralised: the product issuer purchased UK gilts to secure repayment of capital, then entered into a derivative contract to generate an equity-linked return.

This derivative contract was itself collateralised: the derivative provider posted cash collateral daily such that, if the derivative provider went bankrupt, the investor would at least benefit from the value of the contract at that point.

There are many different ways to reduce the credit risk within structured products. Here are just some of the considerations:

• Which assets, if any, are held as collateral? Cash, corporate bonds, government bonds, supranational bonds and equity.
• How are those assets held? Are they pooled or ring-fenced? Who is the Trustee over the assets?
• What is the wrapper for the product? Notes, collateralised notes, notes issued by a special purpose vehicle, or a structured fund. Different wrappers may have different tax implications, as well as different implications for credit risk.
• How diversified are the assets? Is the product backed by a single asset, or a portfolio. If a portfolio, how correlated are the assets?
• Which elements of the product are collateralised? The entire payout, or just the capital repayment element?

With this huge range of possibilities, investors have more choice but investment decisions inevitably become more complex. It is more important than ever that product providers give clear information to investors and advisors, not just on how the payout works, but also on how investors’ money is protected and what will happen if things go wrong.

Decision making - what is the trade off?

Perhaps one of the most important considerations for investors is what they are giving up in order to reduce the counterparty risk on the product.

In general, the lower the credit risk in a structured product, the less attractive its terms will look. For example, the terms available on a structured product backed by AAA government bonds will be less attractive than the terms on a product backed by an A rated financial institution.

In exchange for additional security over the repayment of capital, investors might receive a lower participation rate in any upside, a reduced opportunity for the full return of capital, or their potential returns might be capped at a certain level. This is because AAA assets typically have a lower yield than A rated assets, giving the provider less to spend on the derivative contract.

The choice of wrapper can also impact the cost. Typically, wrappers that offer greater credit protection will also be more costly to set up. For example, it is much more expensive for a product provider to set up a structured fund – a separate entity with ringfenced assets and a Trustee – than to issue an uncollateralised structured note. The terms of the structured note will therefore be much more favourable.

For many investors, it may not be a straightforward decision to select the product with the lowest counterparty risk. A better approach may be for investors to decide what level of counterparty risk they are happy to take, and then look for the best terms across all products that meet that standard.

What is clear is that counterparty risk, as well as payout features, should now form an important part of the decision making process. With the current levels of market uncertainty, we are not saying it will be an easy ride, but if investors know their investment objectives and bring counterparty risk considerations into the decision making process, at least it should be a more comfortable one.

Giuseppe di Stani is a managing director at Morgan Stanley, heading the European Structured Equity Derivatives Distribution team.