By Jane Wallace Guaranteed stock market bonds and Isa products are still taking large amounts of ris...
By Jane Wallace
Guaranteed stock market bonds and Isa products are still taking large amounts of risk to provide high headline income and growth which investors may not fully understand.
The price of options (the derivatives which underlie the product to act as insurance) is determined generally by two factors, the future volatilty of the index, measured as 'implied volatility', and interest rates. The more volatile an index or stock but provides the cheaper the option is attached to it.
Using an index such as the volatile US technology Nasdaq index will allow providers to play to the current trend for tech investing and give more risk-averse investors the opportunity to benefit from the growth in technology stocks with the benefit of some kind of protection.
However, the volatility of this index will help providers in other ways - by lowering the cost of providing attractive terms to investors.
David Wootten, director at Eurolife Assurance, said: "Everyone is piling into technology through unit trusts at the moment and it is logical that structured products should mirror that to an extent. It is cheaper to buy options on a more volatile index and the subsequent bonds are more risky."
Eurolife Assurance already has such a bond out at the moment. International Zero Risk Capital Bond is linked to the Nasdaq and guarantees 100% return of capital after five years, even if the index falls, plus a percentage return equal to that in the index, capped at 60%.
There is also an Isa version, Capital Protected Bond Isa. Wootten said that other providers would most likely have similar products in the near future.
Inevitably, market conditions will inform which type of products are available as pricing varies so dramatically depend-ing on the backdrop at the time of launch.
Whereas two or three years ago there were more capital protected products available, last year there were more income products. This is because last year long-term interest rates came down to 6% from about 8%, while volatility increased by some 25%.
Mark Dickson, head of product development at HSBC Asset Management, said: "The higher the volatility is, the more you can earn by selling options, so providers can give higher income to investors. When volatility is lower, buying protection through options is cheaper, so capital growth products are more attractive."
Generally, the two products work in the following way. For the income product, the provider invests the majority of the money in bonds and sells an option to a third party wanting protection against a fall in the index, for which a premium is paid. The provider uses the premium to pay out extra income to investors, which they keep, unless the index goes down, in which case the provider must pay more than the premium back to the third party.
Dickson said: "Because the total amount of money is greater than that received from investors alone, the provider can offer a high yield. The downside is that if the market goes down, the provider must pay out, and the only place to go is the original capital invested."
Capital growth products are different. The majority of investors' subscriptions are put into normal bonds so that at the end of the period the provider can return the original money to investors plus any interest collected.
Then the provider buys an option on an index, which will pay out if the index goes up, nothing if it does not.
For both income and capital growth products, the length of the term is important. According to Dickson, the fundamental assumption is that an index is more likely to rise over five years than over one, as the market has experienced in general a growth trend. So options are more valuable in the shorter term as they are more likely to be exercised.
Income product providers can get more money for selling their option over the shorter term, leading to shorter term products, while buyers of options get a better deal in the long term, leading to longer-term products.
This is also true of indices. The fewer stocks in the index, the more diversified it is and the less likely to fall. Capital protection is less necessary, making more volatile indices attractive to income product providers, and the less volatile ones even more appealing to growth providers.
As Mike Egerton, vice-president of global equity-linked products at Merrill Lynch, said: "These products are often sold as a conservative means of providing a level income. While they can be quite effective in this regard, the risks taken to achieve the income can, in some circumstances be difficult to ascertain."
For example, the March 2000 report by Merrill Lynch on structured products gave the Zurich Life Five Year Extra Income Bond, which has a headline income of 8.5%, a risk factor of eight out of 10 and a score of 10 out of 10 for chance of capital loss.
Its 50% growth option was awarded a 10 for risk and a five for chance of capital loss. Both had a respectable return score of seven.
The report ranks each product out of 10 for each of four categories: return, risk, chance of capital loss and capital shock factor.
In an ideal world, therefore, the best product would have a score of 10 for return, and one for the risk, chance of capital loss and capital shock factor categories.
In the past, Merrill Lynch has done the analysis for the report on a traditional risk and return method.
But Merrill Lynch has chosen to revise its process and forward-tests the products instead, using, for example, a simulation of 1,000 possible outcomes for the product and taking the average result as the basis for its rankings.
The return category is judged on performance relative to cash. A score of one represents the chance that the product could underperform cash. A score of 10 indicates a return in excess of the cash rate but extra risk may be responsible for that while a score of five s
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