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Collateral thinking

Industry and public concern over counter-party risk following the failure of Lehman Brothers has increased demand for more effective protection strategies in the structured product market.

Gilt-backed structures, collateral strategies and early kickout options are increasingly popular among providers as a way of mitigating risk but they do not come cheap and advisers are divided on whether it is a price worth paying.

Last September, BNP Paribas launched two structured open-ended investment company funds, stabiliser and stabiliser plus, under its newly launched Privalto UK brand.

The six-year plans offer 100 per cent capital protection and potential for growth through an absolute return strategy via the multi-asset absolute return BNP Paribas millennium 10 Europe excess return index.

Backed by AA+ rated BNP Paribas, the funds tackle potential credit risk by placing collateral in the form of AAA-rated G7 government bonds with a third-party depository to reduce potential exposure to the underlying counterparty.

However, while the Oeic structure provides investors with cover from the Financial Services Compensation Scheme if it is unable to meet its liabilities, it also means the fund’s holdings have to keep to Ucits rules.

BNP Paribas retail structured funds director Sisouphan Tran says: “You can create a classic structured product very quickly. It is something that is very flexible for a bank or product provider to issue in the market.

“We have limitations on what assets you can put in the Oeic, as not all are eligible under Ucits rules, such as hedge funds or holding pure commodities, for example.”

Tran acknowledges it is easier to promote capital- protected products in the present climate as investors are more anxious and looking for so-called “safer havens” for investment. But he says: “I hope when we return to a bull market, people will not forget what has happened today.

Tran believes that more collateral-backed Oeics will appear on the market in the future but says this will not happen overnight.

He says: “Logically, you should see more of these types of funds as opposed to the classic debt securities-based products. It will take time and it will require a lot of investment from companies which is not very easy to do in the current climate.”

AWD Chase de Vere senior manager Jason Walker says the firm is already seeing a number of more classic structures emerging on the market which use gilts to provide security. He says: “You are paying for the protection on BNP’s stabiliser by going into it as an Oeic but at the moment that is something some clients are prepared to pay for.”

Aviva is another provider planning to launch a structured product within a Ucits-compliant fund structure.

To mitigate risk, Aviva intends to only use an over-the-counter derivative from a counterparty that meets certain credit rating criteria and will employ collateral arrange-ments through government bonds.

Truestone client director Simon Bullock says gilt-backed structures are very safe but very expensive compared with classic structures which only use one counterparty.

He says: “BNP’s structure is quite new, quite clever and different but I am not sure what kind of upside you will get with that kind of cast-iron protection. If you get a significantly better bang for your buck because you are happy going with one specific counterparty rather than a basket of G7 gilts, the model might remain niche. It may suit discretionary managers but for advisers it would be very difficult to talk through. It has probably got a place but I am not sure it will take over.”

Low interest rates, reduced stockmarket volatility and falling gilt yields mean it is becoming increasingly difficult for providers to structure protected investments that can still offer a competitive payout.

Boutique provider Quantum Asset Management temporarily pulled out of the market last week after struggling to structure products competitively and Morgan Stanley was forced to cut the annual kickout by 1.75 per cent on the latest tranche of its FTSE defensive AAA gilt-backed growth plan.

Tran says it is very difficult to create protected investments which will provide good potential upside for clients at present.

He says: “We launched the funds before all the interest rate cuts and there is a lot of demand from the market to launch a new stabiliser with full capital protection but I am not going to do it now because the participation in the absolute return strategy would be dramatically lower.”

He says the first generation of stabiliser products will be the flagship for the firm’s protected investments range while it considers alternative solutions to complement it. Options under consideration include reducing protection to offer cheaper alternatives or offering direct access to the underlying strategy without capital protection.

Lowes Financial Management managing director Ian Lowes says: “Volatility is down at the moment which is tightening up the pricing on kickouts. You can have all the demand in the world for a kickout contract but if it is just not viable, no one is going to offer one.”

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