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04/26/2011

Sliced & Diced: A Taste of Structured Investments


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A May 2009 report from Research and Markets of Dublin notes that “structured products are among the fastest growing investment classes in world financial markets.” Although not really an asset class, structured investment products represent an array of investment tools for retail and institutional investors. They can enhance the returns of traditional asset classes, provide exposure to hard-to-reach sectors and markets, and often mitigate investors’ risk of losing some or all of their principal.

“Structured products allow for a type of customization of risk profiles that you can’t get from old-school diversification across asset classes,” says Keith Styrcula, chairman of the Structured Products Association of New York, the industry’s trade group. “Structured products can be adapted to every market scenario and market view. Achieving two times the upside return of an index with a 20% first-loss buffer can be extremely appealing and can repair a portfolio with no additional downside.”

An infinitude of structured investments can be created through combinations of components to meet an investor’s goals, horizons, risk–return profile, or directional viewpoint on a market or sector. Unlike open-ended investments, all structured products have maturity dates.

According to StructuredRetailProducts.com, $37.6 billion across more than 7,000 structured investment products were sold in the US in 2008. That sales volume was 13% higher than 2007’s sale of $33.2 billion across more than 6,200 individual structured products. US sales during the first quarter of 2009 were nearly $6 billion.

Structured products are not to be confused with the culprits behind the subprime mortgage debacle. They are sometimes incorrectly identified with the troublesome structured credit products that fueled the financial crisis—mortgage-backed securities, collateralized debt obligations, and other much-maligned engineered securities.

TAILOR-MADE

 Structured investments are engineered investments created to provide either an income stream or opportunity for investment growth. Each investment is built to achieve a particular objective, such as attempting to capture an index’s upward or downward movement, securing a positive return in an unpredictable market trading up and down within a narrow band, tapping into difficult-to-reach sectors that look promising, or even preserving some or all of the principal invested.

An infinitude of structured investments can be created through combinations of components to meet an investor’s goals, horizons, risk–return profile, or directional viewpoint on a market or sector. Large banks will often create regular monthly calendar offerings of off-the-shelf products that have proven popular, as well as offerings tailored to individual needs through a reverse inquiry process. Unlike open-ended investments, all structured products have maturity dates.

Structured investment products are comprised of three basic interrelated parts that can be sliced and diced to suit both the investor and the issuing bank: the actual structure of the investment, the wrapper built around the investment, and the payoff component. The payoff can include various features, all of which are tied back to the formula established at the outset.

STRUCTURING THE INVESTMENT

“All structured products have a component of a derivatives option plus some kind of fixed income component,” says Robert Benson, PhD, the founder and managing director of London-based Arete Consulting Limited and the proprietor of StructuredRetailProducts.com. For example, a typical vanilla structured equity investment may contain a zero-coupon bond plus an equity option, typically a call or put option. Or the engineered investment may contain multiple options and multiple fixed income components.

Benson explains that the “combined package of financial instruments is then used to deliver the anticipated passive investment return based upon a formula, not some kind of active management return.” Individual investment structures and pricing are developed by issuers through the use of computer modeling, software, and good old-fashioned spreadsheets.

The potential performance of each structured investment is tied to a so-called “underlying”—an equity, commodity, currency, real estate, or other domestic or foreign index, such as the S&P 500. Structured investments can also be linked to an underlying such as a niche index, issuer’s proprietary index, or third-party index.

 
  Structured-products-graph

Structured Investment Products, Monthly Issuance and Sales Levels, January 2007–May 2009. Includes listed and unlisted registered notes, unregistered notes, and certificates of deposit. All products are retail Source: StructuredRetailProducts.com, June 4, 2009. Data is © Structured Retail Products.

 Alternately, performance can be linked not to an index but to the performance of a specific commodity such as oil or gold, to an exchange-traded fund, to a mutual fund, to a single stock or a basket of stocks, to currencies, or to combinations thereof. Even specific investment strategies, such as market-neutral long–short strategies, can be underlyings. More sophisticated structured investments can be linked to the yield curve, the consumer price index, and so on.

Current interest rates and market volatility are key to how a bank structures an investment and what features the product offers. For example, a structured investment’s participation rate—that is, how much of the underlying index’s upward or downward performance over the investment term will be captured and paid to the investor—is dependent on interest rates, on volatility, and on whether the bank can buy more or fewer of the component options, Benson notes.

The good news, he adds, is that once a structured investment is created and hedged through the purchase of options, the issuer can basically set it and forget it, at least until maturity, when the calculation agent will determine the final return outcome of the security.

THAT’S A WRAP

Structured investments can be created in different formats or product wrappers. Most commonly, banks wrap a core investment product into a traditional medium-term note that is registered with and regulated by the Securities and Exchange Commission. Foreign banks also offer notes in the US that may or may not be registered with a regulator. Structured notes may be privately negotiated or may trade on a stock exchange.

Structured notes are legally senior, unsecured debt obligations of the issuing bank. They are not collateralized and are dependant on the issuing bank’s credit rating and ability to repay investors at the note’s maturity. If an issuing bank should fail, as Lehman Brothers did in mid-September 2008, investors would become creditors alongside corporate bondholders. Whether they recoup most, some, little, or no return of their investments depends on the failed company’s remaining assets.

Lehman’s bankruptcy became a huge black eye for the global structured products industry when Lehman left many investors holding billions in essentially worthless unsecured structured investments. An immediate flight by investors to banks with high credit ratings also led to a massive surge in market-linked certificates of deposit.

Since then, bank certificates of deposit have become a favored investment wrapper for many market-linked structured investments. Sporting their recently raised FDIC-backed insurance of up to $250,000 per investor through 2013, banks have repackaged many of their more popular structured investments into principal-protected certificates of deposit. Many bank executives expect traditional notes to come back into favor once investors’ jitters subside.

POSITIONING PAYOFFS

Various payoff structures take into account both the market environment at inception and investors’ needs. Because underlying indexes can be unpredictable and move in different ways, payout scenarios can vary.

Partially principal-protected notes are designed to buffer against some specified degree of loss of principal, while 100% principal-protected notes will return all of an investor’s net investment after sales charges, no matter how the underlying performs, as long as they are held to maturity.

Of course, the return of any investment rests with the issuer’s credit quality and financial wherewithal. Moreover, although some degree of principal protection has become popular, many notes offer no principal protection. Instead, their potential for returns is higher.

Several varieties of enhanced-return notes use leverage to generate beefier returns. They may have built-in downside buffers that protect against the first decline in the underlying of 5% to 30% or more. Some may not have any buffer on the downside to protect against a fall in the underlying index; others will cap the achievable upside return.

With absolute-return notes, investors receive a positive payout that equals the absolute change in the index performance as long as the underlying index has a positive or negative return within a predetermined range of performance.

Reverse-convertible securities linked to a single stock typically pay larger coupons than investment in a company’s corporate bond. But if the stock breaches its preset upside or downside price barrier, coupons cease and investors receive no return of cash, only physical shares of that stock. Last year’s volatile market swings caused the majority of outstanding reverse-convertible securities to breach their barriers, according to data from StructuredRetailProducts.com.

Structured products are not an all-or-nothing proposition. Many view them as tactical investments to be used as satellites to investors’ core portfolio holdings. While mutual fund managers, especially those integrating a commodities component, have become fans, structured products haven’t yet fully infiltrated Main Street.

There are other types of structured products for bullish, bearish, or sideways market views. Some pay coupons, some don’t. Generally, the higher the coupon, the greater the risk.

The European structured products market has trounced the US in terms of innovative payout structures, says Philippe El-Asmar, global head of investor solutions at Barclays Capital in New York. Much of the innovation in the US has come through access to themes including India, China, inflationary plays, and long–short strategies. “Issuers are responding to what’s on the minds of investors. All of these innovations are driven by what clients want,” he maintains.

NO SURPRISES 

While structured products vary, most have three to five potential outcomes or return scenarios. Chris Warren, managing director and head of structured products (Americas) at New York’s DWS Investments, the US arm of Deutsche Bank, says that “structured products are good at outcome-oriented, rules-based returns.”

Warren explains that, since possible payout results are shown within the investment offering documents, “what’s unique to structured products is that while you may be happy or unhappy, you should never be surprised at an outcome. The crux of investing in structured products is to understand the product’s return and be sure it matches the investor’s view of the market.”

For example, an investor may believe the S&P 500 will rise 12% over the next 12 months but would like to achieve an outperformance on the upside if the index rises, and some protection on the downside if the index declines. That investor might choose a structured note with two or even three times leverage (meaning possible earnings of double or triple the index’s return) and perhaps a 15% buffer on the downside. The buffer would protect the principal against an index decline of up to 15% from the initial level determined on the pricing date. However, if the index should decline more than the buffer’s protection level, principal would be eroded. While the degree of erosion varies, typically principal might fall by 1% for every additional 1% decline of the index.

SATELLITE INVESTMENTS

Structured products are not an all-or-nothing proposition. Many view them as tactical investments to be used as satellites to investors’ core portfolio holdings. While mutual fund managers, especially those integrating a commodities component, have become fans, structured products haven’t yet fully infiltrated Main Street.

“The top 10% of financial advisors have devoted the time and effort to become conversant in the risks and attributes of structured products,” says Keith Styrcula. “The other 90% may be doing clients a disservice if they’re not carrying out their fiduciary responsibility to use the latest financial technology to manage risk and volatility and enhance returns and incomes with structured products.”

Lori Pizzani is an independent journalist based in Brewster, New York.

This article was originally published in the Summer 2009 issue of the Investment Professional.

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