Structured products are usually designed to be held until maturity – when investors receive a pre-defined, ‘formulaic’ payout. For investors who want to redeem early, there are usually strong warnings in the literature that what they receive may be less than the amount they invested. But just because these investments are designed to be held, doesn’t mean investors don’t have the choice to redeem their investment early. In fact, there can be occasions where investors can use the secondary market to their advantage.
Most providers offer fortnightly or even daily liquidity on their products. This ‘secondary market’ allows investors who have experienced a change in their personal circumstances to liquidate their investment. It also provides an opportunity for investors to lock in gains early if their investments are performing particularly well.
Investors who remain invested until maturity (or a kick-out event), know exactly what returns they will receive: the returns will be as described in the product literature. But what about the price in the secondary market? How is this calculated?
Whilst the price at maturity is formula-driven, and usually just a function of the underlying’s performance (and of course the counterparty being able to meet their obligations), the price in the secondary market depends on many more factors including current interest rates, volatility and the credit quality of the counterparty providing the capital protection.
These factors will impact the secondary market price in different ways. For example, rising interest rates tend to have a negative impact on the price of a capital protected product (as the present value of the bond providing the protection will fall). But the impact of other factors, such as volatility, depends on the product. If volatility for an underlying increases, will this make a higher payout more or less likely? Usually higher volatility increases the chance of a greater payout, therefore the impact on product price is positive. However this is not always the case, especially if the product contains additional features such as a maximum return level.
Exploring the impact of these factors on secondary market prices is a topic in itself, and here we are merely scratching the surface. However, the bottom line is that, in certain circumstances, trading out of an investment early can offer attractive opportunities. For example, falling interest rates and tightening credit spreads have meant that many recently launched products have been pricing well above their issue price. Investors in these products may decide to realise these above-market gains early, rather than keeping the risk and staying invested until the maturity date. They could even decide to enter another product with more attractive terms: perhaps with a higher participation rate, or, if the underlying market has appreciated, to re-base capital protection at a higher level.
Of course, developments are needed to offer a secondary market similar to that which exists in the discretionary space – one which offers daily liquidity, the ability to buy in the secondary market and the possibility to deal a portion of the investment only. There are some immediate obstacles to achieving this: many advisers do not have permissions to trade in the secondary market and paper-based applications create timing issues.
Much more technology is needed before these products become fully integrated on online platforms to make a full secondary market a reality. However we hope the retail market will at least start to move more towards a similar model to the discretionary space. In the meantime, advisers and their clients can perhaps start thinking about taking advantage of opportunities in the secondary market that do exist.
Marc Chamberlain, Morgan Stanley Executive Director
29 September 2009