Yield hunger drives structured note growth

Confidence in structured notes was badly damaged in the credit crisis, but these controversial products have rapidly regained their place in private client portfolios.

Certainly the industry has been at pains to educate investors and become more transparent, but the main driver has been the particular nature of current investment markets, characterised as they are by a fierce search for yield and more recently, concern that stockmarket rises are dislocated from their underlying economies.

With yields at record lows, structured products have been helping investors boost their income, and now, as stockmarkets have soared, they can bridge the gap between fixed income and equities, offering downside protection and even helping time entry into markets.

The big shift in recent months has been a greater use of equities as the underlying asset. “In 2012 there was a lot of traction for credit linked notes but interest reduced and the appeal of equity increased,” says Jean-Eric Pacini, head of structured equity distribution Emea at BNP Paribas. “The quest for coupon-paying structures remains dominant, in a ratio of 4:1, but over the last 12 months investors have been more inclined to opt for indexation on equity markets,” he says. As for the capital guarantee, although it remains important, the current level of rates points to 80-90 per cent guarantee levels, points out Mr Pacini.

For yield enhancement, the best pay-off profile is the Autocallable Phoenix, which pays a coupon of 8-10 per cent. Initially structured for one to two years, these pay out if the index performance is at a certain level at regular intervals. The downside protection is typically 30-40 per cent below the current market price. Investors are still quite defensive and like the certainty of a known and observable downside in the current environment.

Autocallables can also be structured to take a directional view, paying for example 3 per cent on a quarterly basis, with perhaps 50 per cent downside risk. Many are tailored so an investor who takes the view that the index will not drop by more than, say, 20 per cent, will be able to receive a commensurately higher yield.

Reverse convertibles are exposed to similar risks, but pay a lower unconditional coupon of around 6-8 per cent, subject to issuer risk. In contrast, the holder of a Phoenix Autocallable only receives a coupon if the underlying is above a certain level.

FINDING THE RIGHT RANGE

Range accrual notes are an alternative product for investors, seeking a good return with a conservative payoff profile, who believe stockmarkets are currently range bound, yet are looking for the potential to achieve an attractive yield. “Range accruals generate value for the client during observation periods in which the underlying asset’s price remains within a specific corridor,” says Marc Chamberlain, executive director at Morgan Stanley.

“Usually the observations are taken daily during the accrual period, with the product locking away a portion of the coupon for every day the underlying asset is within the pre-defined range. If the underlying asset falls outside the corridor, the accrual stops until such time that that it comes back within the range.”

Morgan Stanley recently arranged a product linked to the FTSE 100 that pays out 7 per cent pa so long as the index stays between 5000-8000.

Structured products can also play a market timing role in portfolios, particularly for investors who missed the start of the rally at the beginning of the year and are keen not to overpay.

“Investors are worried about the right entry point, as markets move higher,” adds Mr Pacini at BNP Paribas. “One popular product has a structure by which investors can gain the optimal entry point. They may start by investing 50 per cent in an index such as S&P or Eurostoxx and month after month, if the index level is below the initial level, then the mechanism is to invest more, and so this helps investors make the transition from fixed interest to equity. It is like pound cost averaging, but adding two tiers of sophistication, only investing when the index is below its initial level and then invested at the lowest point in the preceding month.”

These products are generally on large developed market indices, such as Eurostoxx and the S&P, where the entry point decision is most acute.

For those who think markets will continue to rise, leveraged notes called supertrackers or accelerators provide greater leverage than 1 for 1 on the upside but are structured as 1 for 1 on the downside. “These are attractive for an investor who does not want to invest all his money today, for example if upside leverage is 2 times he can put in 50 cents today for €1 upside but only 50 cents downside,” says Andrew Cooper, director of structured products at Royal Bank of Canada. “The low volatility of equity markets helps to give more leverage.”

Another example is a look back structure designed for investors keen to invest straight away but who may think the market has risen too far too fast and therefore want to take advantage of market falls. The payoff is linked to the minimum price registered by the underlying asset during the observed period, such as if the market falls to 90 per cent of today’s level.

“We are seeing a real shift in favour of equities as clients look for ways to generate safe yield,” confirms Michael Fitoussi, Emea head of private investor pricing, multi-asset group, at Citi. “To that effect, we screen companies offering high dividends as well as solid prospects according to the CDS market. Another investment theme generating interest is the US recovery and more specifically the energy revolution created by the potential positive impact of shale gas on energy companies and the US re-industrialisation.”

He adds that private banks are currently using structured products for three main reasons – as an alternative to cash, to benefit from specific investment themes and also to build and optimise portfolios by providing exposures to underlying assets in a cost-
efficient way, through option strategies or tactical hedges.

RISING VOLATILITY

For example, volatility controlled mechanisms remain useful, although they were more popular when market volatility was higher. As the equity market falls, and volatility rises, this control mechanism limits risk by dynamically adjusting exposure, providing less exposure when the market goes down and more when the market rises – and so it automatically takes care of some of the portfolio monitoring.

Volatility-controlled cap mechanisms can also boost gearing, which is helpful as investors have poor appetite for gearing of less than 70-80 per cent. Improved gearing is also achievable using efficient indices based on low volatility shares, which sits happily with the theory of efficient markets as low volume shares tend to outperform over the long term.

Investors have also been taking advantage of the recent volatility in gold, using a product called a twin win which pays out provided the price does not drop by 70 per cent, but also makes an additional return if the precious metal rises.

“Inflation is another recurring theme with clients,” says Mr Pacini at BNP Paribas. “These products are generally based on a diversified basket of assets, but they might be based on a number of funding plays such as the bonds of certain European governments. Italians have been very keen to take on the risk of the Italian state.”

Investors have become more concerned about reflation. “Clients often like dual currency products because they have diverse currency exposures and so are comfortable expressing views between their different currency pairs,” says Daniel Ellis, head of investment group, UK & CI, at HSBC Private Bank.

“During the first quarter of 2013, sterling was under a lot of pressure and clients took advantage of that, betting it would weaken through £/$ dual currency investments but that pattern has now stopped since sterling’s rally in recent weeks.”

Gold is often used as the underlying and the current volatility in price means pricing looks attractive, he says. “Our most recent product, which is priced in US dollars, offers a guaranteed coupon of 6 per cent pa over one month, and if the gold price closes below $1333 then the investor will receive gold at that level.”

Investors are looking to boost their exposure to the renminbi, in the belief it will become the world’s first reserve currency in a few years. A popular product is the Digital, which pays a high fixed return if the underlying asset rises but if it does not rise, a lower return is still paid.

Notes are often written around one-off opportunities. For example, Apple’s recent debt issue underlined the stock’s attractions and huge cash reserves, and HSBC wrote a series of Apple products with a two year term, based on two times the upside of the stock’s performance subject to a cap of 50 per cent. It also has a product on Dow Chemical and Halliburton that taps into the energy revolution.

If they have not selected specific stocks, investors will typically use a main index such as S&P 500, Eurostoxx, or the Hang Seng, preferring to express view on developed markets. Not many investors use structured products to take a downward view, and there is little interest in ethical indices, with only a few large clients asking for them.

Fewer products are today offered with a 100 per cent capital guarantee as this level is difficult to achieve in a low interest rate environment and so without the availability of a capital guarantee, most products are fairly short term.

Structured products work well where the underlying asset is unusual and hard to access, such as catastrophe bonds. There is also interest in technically complex notes linked to credit default swaps which have been designed to take the default risk out of a basket of high yield corporate bonds or the iTraxx. Some banks are designing dividend-linked products linked to Eurostoxx large caps, which are awash with cash and expected to boost their dividend payments in coming months.

“Across our suite of investment strategies we have seen increasing interest in those providing smart beta or access to typically difficult to reach assets,” says Richard Couzens, global head of product origination, investor solutions at Barclays. “Similarly, we have launched products to deliver returns that are less efficient or impractical to access directly, such as property.”

IMPACT OF REGULATION

Regulation remains a key theme shaping the structured products business globally. “There are consistent themes across the broader regulatory landscape covering increased transparency, disclosure and an element of standardisation with consumer protection at the core,” he adds. “The heightened standards across the entire lifecycle of a product are also driving a convergence trend across the global structured products industry in terms of business process and client servicing standards.”

One side effect of tougher regulation is a convergence between the discretionary wealth space and retail products, which has also put pressure on fees which are now similar to mutual funds at around 65 bspts for a bespoke product linked to an index.