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The cutting edge

Falling interest rates have increased the appeal of income-producing products while falling stockmarkets have boosted the attractions of downside protection. This combination has led to a re-emergence in the popularity of structured products but overhanging this trend is the spectre of the late 1990s and precipice bonds.

Not all structured products are precipice bonds and not all income-producing bonds are classified as structured products, yet there still appears to be the idea that high yield plus derivatives equals precipice bonds.

To alleviate some of the confusion, a few years back the FSA tried to make some sort of distinction and developed two camps. Those products which offered a 100 per cent capital guarantee were in one camp while all the rest became known as structured capital at risk products or Scarps.

That neatly placed things such as National Savings & Investments’ guaranteed equity bonds into one camp and most structured products into the other. However, it did not resolve the issue of labelling products as precipice bonds.

Scarps may not feature strict 100 per cent capital protection but many tend to have a level of soft protection or a floor of, say, 50 per cent. Unless the index or basket of stocks to which the product is linked falls by more than that amount, the investor will get back 100 per cent of their capital. If the index falls by 51 per cent or more, capital is reduced, hence the term precipice.

Unfortunately, that description ended up being given to funds which did a lot more than simply fall off the edge. They decreased investors’ capital at a much higher rate, generally on a two-for-one basis. Not all structured products featured this geared downside but those that did failed so spectacularly that precipice bonds took on a whole new meaning.

Today’s structured products are a lot more transparent and easier to explain from a risk/reward standpoint than they once were, says Keydata sales director Mark Owen. Just as important, gone are the days of the geared downside.

However, the problems seen at the turn of the century are still causing waves with the sale of products today. When the fallout of precipice bonds occurred, professional indemnity insurers took hard lines with advisers selling any structured product and Owen says the situation has not improved much since then.

One recipient of some perhaps unfair comparisons to high-yielding structured products has been Blue Sky Asset Management, following its launch last month of an income plan linked to a basket of financial stocks and offering a 10 per cent a year coupon.

Having closed on February 8, Blue Sky chief executive Chris Taylor says the plan exceeded expectations in terms of investor interest. The firm is also managing Chartwell’s income plan which it launched on February 11, also offering 10 per cent yield.

Taylor says just because the product has a double-digit coupon does not mean it should be confused or aligned with products of the past that were advertised using a high headline yield. He notes that the original scope of the product allowed for a 14 per cent coupon but the firm re-engineered the product to bring it down to 10 and allow for greater investor protection.

The Blue Sky product allows for a drop of 65 per cent in the value of the stocks to which it is linked before capital is reduced. It was also constructed around stocks that have already experienced a sharp fall in their value compared with those in the late 1990s which were constructed against the ever rising Nasdaq or baskets of tech stocks.

Taylor says Blue Sky’s philosophy in constructing products is never to increase the downside on a product and never use intra-day levels, a practice that makes structured vehicles more opaque and which still exists to some extent in the industry. Providers using intra-day levels pay attention to the levels of the market throughout the day, which could trigger the product’s floor. Intra-day prices are not published, which makes it difficult for an investor to follow the progress of their investment. Taylor says his firm only uses closing prices.

Commenting on how structured products have developed over recent years, Owen says: “Today, it is very clear what the investor is getting and you can draw out the risk and rewards on products very obviously. If you think the market is going to fall by more than 50 per cent, why buy a product linked to the market in the first place? Why wouldn’t you have it on deposit?”

Owen and Taylor agree that demand for income has been on the rise and is leading to greater numbers of products offering attractive coupons.

Taylor says he is seeing greater interest from stockbrokers than in the past and also says discretionary fund managers and fund of fund buyers are using more structured investments.

John Husselbee, chief executive of multi-manager firm North, says the traditional places for yield – bonds and equities – are under pressure and investors are wary as a result of the credit crunch and liquidity crisis sparked by the US sub-prime issues. He has bought structured investments in recent weeks, seeing good value in vehicles that can offer returns in the neighbourhood of 22 per cent, comprising 12 per cent capital growth and 10 per cent income.

If structured products – and not just the income-producing ones – truly have become more transparent, better value and less engineered than in the past, then PI insurers and intermediaries alike will have to start paying attention to what these types of vehicles have to offer, particularly in today’s market where the appeal of downside protection would appear to be growing.


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