Returns on structured products can vary depending on what type of structure is used to achieve the capital guarantee. It is important to understand the differences to make the right choice for an investor
Investors who have suffered a major reduction in the value of their wealth remain naturally cautious towards putting more money at risk. The past few years have clearly confirmed it is impossible to invest in shares without running risks. In recent years, many so-called capital guaranteed structures have emerged providing investors with some peace of mind. For some investors this is sufficient in itself, but for intermediaries with clients interested in a more detailed explanation, some analysis of the underlying structures might be of help.
A look under the bonnet
You expect the marketing brochures to eulogise about the unique features of the capital guaranteed structure, but they seldom disclose how the capital guarantee is achieved. Although you can find a variety of structures with different 'pay-off' features, the current market is dominated by two basic structures designed to achieve the capital guarantee:
1. The 'bond plus call' structure.
2. CPPI (constant proportion portfolio insurance) structure.
The two structures share two common features:
• Both structures guarantee the investor will receive 100% return of capital invested, at the maturity of the investment period. This guarantee is provided by the issuer of the investment product, regardless of the performance of the underlying investment.
• In addition to the return of the capital, the investor will also receive a proportion of the performance of the underlying investment. This proportion is known as the participation rate or gearing.
However, while the structures share these two features, and can appear similar to an investor, they actually work in quite different ways and offer relatively different risk/return profiles. It is important for an investor to be aware of and understand these differences before making a decision regarding which structure, if any, corresponds best to the investors' particular needs.
An easy way of understanding the structures is by cutting the whole into pieces. Using a simple structure as an example (taken from a randomly chosen marketing flyer), this product is linked to the performance of the FTSE 100 index and has a five-year investment period.
The question is asked: Where can you get a 100% secure investment plus an uncapped return of 70% of the increase in the stock market?
This answer is 'with this product' but looking more deeply, what are you actually buying?
• A 100% secure investment. In other words you invest £100 and, at maturity, you are guaranteed to get the full amount back.
• An uncapped return of 70% of the index. So, if the FTSE 100 index has gained 100% after five years you receive £100 plus an additional £70.
Basically the structure can be viewed as having two components:
• A zero coupon bond.
• Call option.
Let us say a current five-year zero coupon bond can be bought for £75. This bond will grow to £100 at maturity and the capital guarantee of 100% is achieved.
The remaining £25 is used to buy the call option that enables the investor to participate in 70% of the rise of the FTSE 100-index. The participation rate of the product is determined by the cost of the call option, and the money available to be invested in the call option. The participation rate is calculated by the following formula:
ParticipationRate = Premium available
Cost of option
The amount of premium available to be invested into the call option is the difference between the issue price of the product (£100) and the cost of the zero bond (£75). If the cost of a five-year (at-the-money) call option is £35.71, then the participation rate will be:
ParticipationRate = £25 = 70%
From the above it can be seen that the participation rate is largely determined by:
• The level of interest rates. As interest rates rise, the premium available to be invested will increase, and the participation rate will rise.
• The maturity of the product. The longer the maturity of the product, the greater the premium available, and therefore the higher the participation rate.
Importantly, the return of the product with the 'bond plus call' depends solely on the performance of the FTSE 100 over the life of the product, as calculated at the date of maturity. The path the FTSE 100 has taken over the course of the five years does not impact the final value of the product. So even if the FTSE 100 plunges early in the life of the product but subsequently recovers strongly to end the five years with a positive return, the investor would receive 70% of the final performance - it would be unaffected by any drawdowns or volatility that the FTSE 100 may have experienced over that period.
The second structure, the CPPI, differs in several aspects from the 'bond plus call.' Most importantly, the CPPI will have a participation rate that will vary over the life of the product, in contrast to the previous structure where we have seen the participation rate is fixed.
The basis of the CPPI structure is that the proceeds of the product issuance will be invested into two assets, the reference underlying investment (for example a mutual fund) and highly-rated zero coupon bonds. The amounts invested in each of these two assets will vary over time, depending upon the performance of the fund. If the fund performs badly, the proportion of assets invested in the fund will be reduced, and the proceeds invested in the bonds. When the fund performs well, the proportion of the assets invested in the fund increases, and the allocation in bonds reduced. So it can be seen that the participation rate of the structure will vary over time, depending upon the performance of the fund.
The mechanics of each product will differ slightly, but they broadly follow the same basic theme. On the day of investment in the product, the issuer will calculate the cost of the zero coupon bond. As in the previous example, a five-year zero coupon bond cost £75. The issuer will then subtract the value of the zero coupon bond (£75) from the value of the product (£100), to calculate the product equity (£25). This equity is then multiplied by a prescribed 'leverage factor', typically four, to calculate the initial participation rate: in this case £100 (four times 25). The issuer will therefore invest 100% of the assets in the fund, and zero in bonds.
The investor is receiving an initial participation rate of 100% - in other words, the investor will participate in 100% of the performance of the fund. This is clearly preferable to the previous structure, where the investor received a lower participation rate. However, with the CPPI structure, this participation rate will depend on the level of the product equity, and this will vary over the life of the product depending upon the underlying fund.
This can work to the investor's advantage: if the equity component rises in value, the product's equity will also rise and the participation rate may even increase to over 100%. This would be achieved by borrowing money from the issuer in order to invest in the fund: this is called leverage. This can lead to the product actually out-performing the underlying investment.
However, the reverse is true if the fund starts returning negative performances. If the fund loses 10% of its value in the first month, this would mean the value of the product would fall to £90. The product's equity, therefore, has fallen from £25 to £15 (in other words 90 minus 75). The issuer will then apply the leverage factor to this new level of equity, to arrive at the new participation rate of 60% (four times 15). The issuer will have to sell part of the holding in the fund in order to reduce the amount invested to £60, and allocate the proceeds into bonds. The product has been partially 'deleveraged', and the participation rate is now 60%.
This process continues over the life of the product. In the extreme case, but certainly not unknown, of sustained poor performance by the fund, the value of the product's equity may fall to zero. This results in the product being completely de-leveraged, so the investment in the fund falls to zero, and all the product's remaining assets are allocated into bonds. At this point the product no longer has any exposure to the fund and, even if the fund were subsequently to recover and end the five-year period with a positive return, the investor would only receive the return of the original amount invested.
It is clear that in the case of the CPPI product, the return the investor receives at maturity depends not only upon the final value of the fund, but also on the course or path which the fund has taken over the life of the product. This is because the participation rate of the product will vary depending upon the fund's performance over the life of the product. This is in contrast to the 'bond plus call' product where the investor's return is purely determined by the final value of the underlying, as the participation rate is fixed.
In recent years, many capital guaranteed structures have emerged providing investors with some peace of mind if they are cautious about putting their money at risk.
The 'bond plus call' and the CPPI structure can appear similar to an investor, but work in different ways and offer different risk/return profiles.
It is important an investor is aware of the differences between the two when making a decision and chooses the one that corresponds best to their needs.
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