David Rumsey (pictured), Head of Multi Asset Product Team UK, HSBC Private Bank comments on the developing role of structured products in a challenging environment…
Investors are having a tough time finding attractive returns in a climate of very low interest rates, low growth and slowing equity markets. Potential growth areas such as emerging markets and commodities are sometimes difficult to access. Portfolio allocation is tricky when markets remain prone to risk events from political turmoil in the Middle East and North Africa, European sovereign risk downgrades and fiscal bail-outs.
We believe that structured products can help overcome some of these problems even if the current environment has become more difficult for structured products as well. However, these difficulties do not invalidate the role structured products can play in portfolios, even if they do mean that the structures themselves have had to be adapted to changing circumstances.
Interest rate conundrum
Structured products are built on zero coupon bonds that are issued at a discount but mature at face value. Current low interest rates mean that the discount is relatively limited, and that investors are left with very little to purchase exposure to growth through options.
In our view, we will continue to witness a low interest rate environment in the US, the Eurozone and the UK as monetary authorities seek to support fragile economic activity.
Although the ECB has raised policy rates by a quarter of one percent recently and is taking a more active stance on adjusting to inflation risks, interest rates remain at extremely low levels in the US and the UK and the prospect of a return to ‘normality’ seems to be ever receding as economic data has been disappointing.
Medium-term interest rates remain very low, below 1% in USD and around 1.5% in GBP. The Federal Reserve and the Bank of England hope that inflation will be a temporary phenomenon and money markets seem to agree, for now. The yield curve is normal and not excessively steep which means that even for 5-year maturities and allowing for the liquidity premium, rates are historically low.
Investors who seek returns above cash without taking capital risk are turning to floating rate returns which are linked to LIBOR. Structured products can offer a minimum return above the current LIBOR rate in exchange for capping the coupon in case LIBOR were to rise dramatically. These returns are contingent on the funding requirements of the issuer and, as ever, higher returns typically involve higher credit risk. As such, they can be tailored to an investor’s level of risk appetite. These ‘collared’ floating rate notes may perform better than traditional floating rate notes if central banks do not hike interest rates by much, or only hike later in the product’s life. We believe that the recent weakness in economic data is likely to delay the timing of interest rate hikes in the West.
Equity markets have rallied strongly since the depth of the credit crisis, but have stalled recently, and the outlook has become muddied due to faltering global growth and soaring commodity prices. With lower expectations ahead, growth-linked structured products may have become less attractive.
Given low bond yields, it has been necessary to extend product maturities further and further in order to achieve capital protection and participation in the upside of a particular equity index. This does not always fit investors’ maturity or liquidity requirements, and may make such products unsuitable. It is nearly impossible to structure short-dated products with equity-type returns without taking capital risk or high credit risk.
On the whole, we believe that by taking a defined, sensible and considered degree of capital at risk, we can still achieve rewarding returns in equity markets in spite of the current low bond yields. Increasingly investors seem prepared to countenance conditional principal at risk (through barrier options), to enable growth and leveraged potential growth returns. This also applies to products that may deliver an enhanced coupon or bonus payment if downside barriers are not breached.
The volatility environment
Returns will vary according to a number of factors, but implied volatility is a key driver. Investors can benefit from selling volatility (selling options), but they have to be aware of the risks. In bear markets volatility tends to rise and this can create conditions for relatively high defined returns to be manufactured by monitoring the performance of a single index for a relatively short period. These conditions existed two years ago but now volatility is closer to ‘normal’ levels and as a result selling volatility generates less income. Products have therefore evolved to target specific stocks, baskets of stocks and baskets of indices, rather than individual indices in order to construct appealing coupons. In adapting to market circumstances, structures that include conditional coupons and conditional capital at risk are being offered. An added feature that can enhance returns is to include an early-redemption clause if the underlying performance meets specific criteria. There are endless variations to the theme and products can be tailored to investors’ requirements.
As these products have evolved, we believe that a clear understanding of risk and reward profiles for each product is necessary before investing.
Currencies as an asset class
As the tired old currencies of the US, the Eurozone and the UK are undermined by soaring debt levels and easy monetary policy, investors look to the currencies of economies with strong growth and high yields. In our view, they are increasingly found in emerging markets, particularly in Asia and Latin America. As these currencies are not always deliverable, structured products have been increasingly used as vehicles for accessing them.
A structured note can deliver a participation in the appreciation of a basket of emerging currencies from current spot levels while providing capital protection in the event of depreciation. This principal protection may be set at 100%, although by foregoing a modest amount of protection the investor can multiply the potential return.
While BRIC (Brazil, Russia, India, China) notes are often the first step into emerging markets, they are not the only option, with several combinations of different currencies available, while weightings can be adjusted to the investor’s requirements.
Structured products are facing the headwinds of low interest rates and relatively low volatility. But in our view, they have demonstrated that they can adapt to changing economic circumstances, and especially so in difficult scenarios where traditional assets face issues of their own.
Structured notes can –
- provide different degrees of capital protection;
- enhance returns in low growth, low yield markets;
- enable investors to implement their risk reward profiles;
- and provide access to some markets that are not available through ‘traditional’ investments.