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Structured deals double up

A few years ago, investors looking for a structured product which offered a full capital return regardless of index performance and 100 per cent growth in the index would have been on a wild goose chase.

Products that provided returns of 100 per cent or more tended to be precipice bonds where capital was at risk. Some products had a cliquet structure where index gains and losses were totted up during the term, making 100 per cent growth impossible to achieve.

Similarly, products providing a full capital return would only offer 100 per cent growth up to a capped level, for example, 70 per cent. Products would also limit returns through a participation rate, where investors would get a percentage of growth uncapped but this would always be below 100 per cent.

However, providers such as Nvesta and Woolwich Plan Managers are now able to market products which combine 100 per cent capital protection with 100 per cent growth in the FTSE 100 index. They can do this because of the underlying structure and influential factors such as interest rates.

Structured products are made up of two parts – zero coupon bonds and derivatives. Part of investors&#39 capital goes into a zero coupon bond to provide the capital guarantee. A zero coupon bond is similar to a deposit account but instead of accruing interest each month or year, it is rolled up until the end of the term.

The remainder of investors&#39 capital, less costs such as IFA commission and provider profits, will go into derivatives. It is the portion that goes into derivatives, including FTSE 100 call options, that is used to achieve the returns.

A call option is a contract between the product provider and a bank which gives the provider the right, but not the obligation, to buy the value of the index at a set price before a certain date. If the index falls, the provider loses only the premium it paid for the option. But if the market rises, there will be a return on top of the capital protection.

Explaining how Nvesta&#39s capital secure tracker can achieve 100 per cent growth and a 100 per cent capital return regardless of index performance, Nvesta managing director Graham Devile says: “Interest rates are on the up so we do not need to spend as much to get 100 per cent capital protection.”

Put another way, when interest rates rise, product providers need to put less of investors&#39 capital into zero coupon bonds to meet a 100 per cent capital return, so they have more to put into derivatives, which leads to higher growth potential. However, derivatives are more expensive when interest rates are high and product providers need to explore various measures to ensure they profit.

Independent Personal Financial management proprietor Luke Gibbon thinks that providers are going back to basics with a full capital return regardless of index performance capital because of the FSA&#39s stance on structured products that potentially put capital at risk.

Consultation Paper 188 is concerned with the marketing of products offering income, growth or capital security, so consumers are not misled about what they are buying and the risks involved.

Gibbon says: “There has been a great deal of bad press about precipice bonds. Lloyds TSB was fined heavily and some precipice bonds that reduced capital by 2 per cent of capital for every 1 per cent fall in the index lost investors all their money.

“If you go back far enough you used to get guaranteed income bonds that returned the original capital less any income taken. So you could say to clients that all they would stand to lose was the interest they would get on building society accounts. I think that we are now reverting back to that idea but the bonds are now offering growth because they cannot provide a high enough income to get that level of capital protection.”

Providers such as Abbey offer a full capital return plus a minimum level of growth regardless of index performance, although the growth potential is lower than those which offer a 100 per cent capital return. These products are structured by putting more into the zero coupon bond element and less into derivatives.

Abbey head of investment marketing Pak Chan says it is possible to do this because of the long-term outlook on interest rates, which affect the money markets. He says: “Base rate changes affect the future money you can get on the money markets. Yield curves, which are based on long-term views on interest rates, are fairly healthy and this allows us to offer better deals to our customers.”

Gibbon can see the merit of these products but has one main criticism. “With products offering, for example, a 120 per cent minimum return, IFAs could say to clients that they will get the same as on a building society but this is not exactly the case because we do not know what future rates will be,” he says.

A recent development in the structured product market is the longer-term product which has an early maturity feature that kicks in if the index reaches a certain point at a certain time. According to Arete Consulting, the company behind data collection website Structured Retail Products, there were 24 products with an early payment trigger last year, compared to just one in 2002.

Providers create these products by using derivatives which have an exercise date. If the index reaches a certain level on that date, the option must be exercised and the product will mature.

This structure enables providers to offer 100 per cent capital protection and 100 per cent growth if the product runs full term, as growth occurs more slowly due to the longer term. But the early maturity mechanism reduces the chance of this happening, thereby ensuring that there is a still a profit margin for the providers.

As Legal & General PR manager, savings & investments, Steve Leach says: “The greater the risk to the product provider, the more they ask consumers to pay for that.”


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