The evolution of species is usually a slow and steady process. A similar pattern is normally seen with financial products. Over the years, new features or related services are added to gain competitive advantage or allow the products to adapt and serve different customer needs.
Studies of evolution have shown that periods of exceptionally fast change in species are driven by rapid changes in the external environment. Rapid changes in the financial environment help to explain the exceptionally fast development – and now decline – of guaranteed products in the UK. This article examines the history of guaranteed products and considers some issues for the future.
The market for guaranteed bonds started to become significant in the early part of this decade. Sales reached a peak in the latter half of 1996 and have since seen a fairly steady decline. The outlook for such products was initially very positive. They appealed to customers by offering an attractive level of participation in stockmarket growth together with a guarantee – hence they appealed to the more cautious medium-term investor. In recent years, however, the environment has been changing rapidly. Two major trends have particularly had an impact upon guaranteed products – declining interest rates and increasing market volatility.
Simply, the cost of providing guarantees depends on the prevailing rates of interest. When interest rates are high, the amount of money required to provide a guarantee is low. When interest rates fall, the cost of the guarantee increases. At the end of 1996, bond yields of 7.3 per cent were achievable. To provide a guaranteed return of premium after five years, it would be necessary to set aside 70 per cent of the premium. Today, yields have fallen to around 4.6 per cent, which means the cost of providing the same guarantee is 80 per cent of the premium.
The cost of providing stockmarket participation through the use of options, as generally employed in guaranteed products, depends partly on stockmarket volatility. Levels of market volatility have increased markedly over the past 18 months.
In 1996, when guaranteed bond sales were at their peak, one measure of volatility stood at 15 per cent. By the end of 1997, the rate had almost doubled and, during the market turmoil at the end of 1998, the level of volatility was three times the level experienced
Things have calmed down somewhat since then but volatility remains twice the 1996 level. This means the cost of providing the stockmarket upside within a guaranteed product has increased substantially.
The effect of these two trends has been that guaranteed products have been offering the customer less and less and the changes have occurred at a rapid pace. To maintain an offering with an attractive “headline” participation rate, more and more exotic products were produced. The worst of these were the so-called precipice bonds, whereby everything was fine unless one of a number of stockmarket indices fell, in which case a substantial capital fall was incurred. These were clearly open to customers not understanding the risks involved and potential adverse consequences at maturity.
Concern about these products was such that the Treasury made it impossible to market products like these which were linked to more than one index. The prospects for the guaranteed bond market do not now look particularly positive. The cost of options remains high and we see relatively few new offerings being developed.
Advisers will need to reconsider rolling guaranteed funds, which have proven popular as investment options under life or pensions contracts. The contracts typically offer a guarantee of between 95 per cent and 100 per cent of capital after a period of three months.
The nature of these funds has changed markedly over the past few years as the changes in market conditions have had an impact on them in a similar way to the single-premium bonds discussed above.
Three years ago, these products offered attractive rates of participation in the equity market together with a guarantee. Now the available participation rates look very unattractive and it would be necessary for the stockmarket to grow very strongly if they are to produce returns that compare favourably with cash deposits. The changes in market conditions have made many such funds behave very differently from when they were first sold.
The key message is that the nature of guaranteed products does change over time. In cases where the investor has locked into guaranteed terms, many will have locked into very attractive participation rates by today's standards. A nasty surprise may be waiting for investors in the more risky type of structure. For those in rolling funds it will be vital to ensure that the investment vehicle continues to meet their needs.