There has been plenty of bad news around the structured products industry recently, but it’s not all negative.
First, the market and asset class forecasts for 2010 are varied. There was a real danger of further asset bubbles appearing as a result of the continued low interest rate environment. It’s fair to say attitudes to risk are being rewritten, and managing volatility is just as important as diversification for a client’s portfolio. Structured products offer a means of protecting against downside and allow for positive returns in either rising or falling markets.
The prime drivers in pricing structured products are interest rates and volatility. Interest rates may well remain low in the UK for the foreseeable future. This makes the cost of repaying the investors’ initial capital historically high, but on the other hand it reduces the price of buying call options (buying the upside, for instance). Conversely, low rates increase the value of put options, so soft protection benefits. Hence, a low interest rate environment may be beneficial for growth-orientated products using soft protection barriers.
Meanwhile, volatility has fallen back a long way from the levels seen at the height of the credit crunch. Presently, 30-day volatility stands at around 18 per cent on the FTSE compared with over 30 per cent a year ago. Movements in volatility have a dramatic impact on option pricing. Low volatility means the cost of buying options is lower, so buying upside protection is cheaper. Conversely, soft protection is created by selling an option and less money will clearly be received in a low volatility environment, leaving less money to buy upside. Hence, volatility is a double-edged sword.
High volatility means the cost of buying upside is high. With soft protection products, more money is received for selling options, hence the amount available to buy upside increases. With the present low interest rates and with volatility having fallen back a long way from levels seen at the height of the credit crunch, soft protection products that provide growth pay offs are more attractive all round from a cost perspective.
As rates and volatility have an impact on structured products, there are opportunities to buy cheap growth, particularly if clients are bullish and prepared to accept downside risk. It is therefore worth keeping an eye on what is happening in the broader market to ensure you are getting the best product for your client at that time. The table below offers a simple illustration of how the common parts of a structured product are affected by the two most important valuation variables.
This year should see more growth products issued, particularly as investor confidence in equities seems to be returning. In particular, a wider variety of underlying assets – such as property, commodities and overseas markets – will appear. Also, products offering higher levels of upside return and conventional downside (i.e. if the market falls, so does the investment).
So growth products are likely to be attractive. The Isa season is upon us, meaning income will be in demand in the first part of the year. The benign outlook for growth is not so attractive for income. To understand why, consider the construction of a typical income product, the reverse convertible. A reverse convertible consists of buying a zero coupon bond, selling a knock-in put and buying a swap to provide income.
The zero coupon bond and the knock-in put combine to create the return of capital and the soft protection, and the remainder of the investment is used to purchase a swap to pay the income.
The high (relative to conventional deposits) level of income from these products is achieved because as the put is sold, the investor receives premium (the price the buyer of the option pays). In a low interest rate and low volatility environment, the amount paid will be low, meaning less money for the swap and, therefore, lower income. However, all is not lost on the income front as long as investors remember the higher the returns, the higher the risk.
It is still possible to create products that have the chance of paying income rates far in excess of deposit rates. This can be done by taking on higher levels of credit risk (the chance of the bank behind the product going under) or accepting the level of income might vary, as with an equity income fund where the level of future dividends is unknown.
Two pay-offs that can lead to higher levels of income are accruals and event dependent coupons. For the very high-income seeker, both types of product are already available.
The FSA review carried a lot of positive comment for the industry. Investors will benefit from the high level of disclosure required from product providers. In addition, the FSA requires providers to assess the suitability of products in terms of likely returns, and the risks to income and capital inherent in the product.
Again, this can only be a good thing. All that is needed now is an industry standard for assessing risk and reward that is easily understood. Hopefully, issues such as this will be addressed in the coming months. Perhaps if advisers create enough fuss, some of the mutual fund rating companies might look at this. After all, there must be an interesting business opportunity here, particularly for the ‘first mover’.
The advent of the Structured Product Association is also to be welcomed. An industry body has been long overdue to counter the plethora of ill-informed comment we see published on the subject of structured products.
The structured product industry may be battered, but it is far from knocked out. With market outlooks as they presently stand, structured products can offer clients value, opportunity and peace of mind. Expect to see considerable growth in the use of these exciting products in 2010 as advisers’ and their clients’ understanding of the benefits and possibilities of structured products increases. Exciting times are ahead.
MAIN POINTS
As rates and volatility have an impact on structured products, there are opportunities to buy cheap growth, particularly if clients are bullish and prepared to accept downside risk
Soft protection is created by selling an option, and clearly less money will be received in a low volatility environment, leaving less money to buy upside. Hence, volatility is a double-edged sword
With the present low interest rates and with volatility having fallen back a long way, soft protection products that provide growth pay-offs are more attractive all round from a cost perspective
It is still possible to create products that have the chance of paying income rates far in excess of deposit rates. This can be done by taking on higher levels of credit risk (the chance of the bank behind the product going under) or accepting the level of income might vary.