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Structured products that rely on “counterparty” banks to protect investors’ capital have become riskier as a result of the worsening eurozone debt crisis, according to advisers and product providers. But new products that hold gilts as collateral, or use multiple counterparties, are seeking to limit the risk – while offering returns of up to 8 per cent a year.
In recent weeks, UK and European banks have seen their credit ratings downgraded, as markets have expressed growing concern over their exposure to Greek and other euro-denominated debt. Because structured products make use of these banks’ own bonds, to deliver a return of investors’ capital at the end of their terms, they too have appeared less secure.
Ian Lowes, managing director of advice firm Lowes Financial Management, which runs the CompareStructuredProducts.com website, says: “If the euro crisis has led to a situation where it is more likely that a bank will default then, yes, it has increased counterparty risk. The downgrading of institutions by credit rating agencies obviously serves to increase the perception of it.” Colin Dickie, managing director of investor solutions at Barclays, agrees. “Higher priced credit default swaps (CDS – the contracts that provide protection against default) and financial downgrades have brought counterparty risk to the fore.”
Some argue that the perception has grown faster than the risk itself. “We have been in a heightened risk environment for four years, so maybe the crisis has increased the awareness of counterparty risk for European institutions, where originally the fears were concentrated on US and UK financials,” suggests Marc Chamberlain, executive director at Morgan Stanley.
Tom Becket, chief investment officer at PSigma Investment Management, believes the products themselves are not that much less attractive. “Given the perception that all structured products are risky and evil, the latest onset of the Greek and European tragedy has not caused a material deterioration in structured products’ prices,” he notes.
Using CDS pricing, James Maltin, investment director at Rathbones, calculates that counterparty risk has increased far less than investors might expect. “Using Santander as an example, to insure against default today costs 4.16 per cent per annum, while two weeks ago that same insurance could be bought for 3.97 per cent – a change of just 19 basis points, hardly indicative of any great shift.”
|Index performance needed for return||Potential return||Index performance needed for loss||Potential loss|
|Barclays Defined Returns Plan (Annual Kick-out)||Barclays Bank||FTSE 100 at, or above, initial level on anniversary*||8.25% for each year held*||FTSE 100 more than 50% below initial level at end of term||1% for every 1% index is below initial level at end of term|
|Morgan Stanley FTSE Best Entry Growth Plan 9||Morgan Stanley||FTSE 100 above ‘best entry ‘ level at end of term**||5 times any rise in FTSE 100**, maximum 100%||1% for every 1% index is below initial level at end of term|
|Morgan Stanley FTSE Booster Plan 5||Morgan Stanley||FTSE less than 50 per cent down at end of term||Final index level as a percentage of initial level, multiplied by 2||2 times percentage fall in excess of 50 per cent|
|Notes: *From second anniversary **From best entry level – the lowest of 14 weekly closing index levels measured from July 2 to October 1; Source: www.comparestructuredproducts.com|
However, several issuers have created products that aim to neutralise, or reduce, this risk.
Last week, Barclays launched a new six-year FTSE 100 “Autocall” that pays out 8.25 per cent a year for each year held if the index is above its starting level on an anniversary – and holds gilts as collateral for the value of the investment. Morgan Stanley has previously offered gilt-collateralised plans, but this is the first time Barclays has done so.
Investec has just closed its own six-year FTSE 100 “Kick-Out plan 2”, which offers 9.5 per cent a year if the index is higher on any anniversary – and holds securities issued by HSBC, Nationwide Building Society, Santander UK, RBS and Lloyds TSB as collateral – or cash or gilts.
Earlier this month, Gilliat offered a structured deposit which also used five deposit takers to diversify counterparty risk while offering FTSE-linked returns and protection of original capital.
“The idea of backing a product with gilts is to remove the counterparty risk as much as possible, leaving the investor with only the investment return to consider,” explains Dickie. “The crisis has driven the yield on these gilts to record lows as they are seen as safe harbour in the storm.
In the current market conditions, both gilt-backed or multi-counterparty products can look more appealing, advisers argue – even though the payouts they offer will be lower than those from other plans.
“Investors may feel more comfortable investing in one of these products than in a product backed by a single counterparty,” says Lowes.
Becket at PSigma is already using them. “Structured products collateralised by high-quality government bonds remain investments that we admire and use regularly within portfolios,” he says. “In short, we believe that the attraction of the government bond backed products has improved even further during the ongoing periods of market stress.”
He cites the gilt-backed Fundlogic FTSE Accumulated Income II fund, which will pay 6.4 per cent a year as long as the FTSE 100 trades between 3,800 and 7,500.
Chamberlain suggests that, ironically, the European debt crisis is creating an opportunity to buy lower-risk products. “We have seen some interesting defensive autocalls linked to Euro Stoxx as a medium term recovery play. Clients are using the attractive pricing environment to create products that may not shoot the lights out but return a decent level of income or growth combined with defensive features. I suppose a little bit or austerity has even crept into the market.”
Even so, Lowes believes it is up to investors to check that a product offers the appropriate level of return for the counterparty risk being taken on. Among his firm’s “preferred” plans is the Morgan Stanley FTSE Best Entry Growth Plan 9, which offers to return five times any rise in the FTSE 100 Index – but measured from the “best entry” starting level: the lowest of 14 weekly index levels from July to October.
“The attractiveness of the terms of their plans is, however, at least in part, a function of their perceived credit risk,” he notes.
For some, though, the complexity of collateralised structured products is unnecessary.
“The euro crisis is just adding to the fear that investors have in just about anything,” says Mark Dampier, head of research at broker Hargreaves Lansdown. “Why would I want to buy a structured product? If I want some kind of defensive investment, it’s not hard, I invest a little less and use that great uncorrelated asset that’s called cash. Easy, simple understandable, transparent.“