Nobody likes to lose money – especially not investors, who understand the market’s inherent risk/returns trade-off, but still want some assurance that they’re going to get out at least what they’re putting in. Structured products offer exactly that, providing access to various asset class exposures along with a level of capital protection.
So why isn’t everybody demanding that these types of investments form part of their portfolio?
Probably because most investors don’t know very much about them.
Historically, these products were predominantly available to high- or ultra-high-net-worth clients, according to Fundiswa Pikashe, Head of Distribution: Structured Solutions at Absa Corporate and Investment Banking.
Currently, the usage of these products is far more prevalent than it was a decade ago, due to significant advancements made during this time. Now, structured products are considerably more accessible, allowing us to cater to a broader demographic of investors – including individuals, corporations and trusts – with both onshore and offshore options available across various platforms. The increased demand for these products has resulted in reduced minimum investment amounts and improved cost efficiency, leading to greater inclusion of these innovative solutions in investors’ portfolios.
How structured products work
Structured products can deliver on the dual promise of capital protection and market-linked returns through the basic construct of a zero-coupon bond with a call option. “Take a basic example of a five-year note tracking an equity index with capital protection at maturity. First, you must solve for capital protection, and we do that in the form of a zero-coupon bond,” Pikashe explains. “We’ll go to the bank treasury and say, ‘If we want R100 back from you in five years, how much do we need to give you today?’ If that’s R70, for argument’s sake, we’re left with R30 to buy exposure to an underlying equity index. We do this by buying a call option, which gives us the upside in the index. These two instruments are then delivered in the form of a note issued by the bank.
For investors to enjoy the full benefit, they must remain invested for the full term (typically five years). “If you exit early, your zero-coupon bond won’t have pulled to par yet,” says Pikashe. “Depending on the performance of the underlying equity index, that call option might be in or out the money – and that would affect the value of that investment at any given time in the market. That’s why these products are structured to term.”
From that basic construct, structured products have evolved to shape, diversify – and potentially increase – their pay-off from risk assets (like equities). “A very basic structured product like this would give you full capital protection after five years, together with the upside of an equity asset (for example, an index like the FTSE/JSE Top 40 or S&P 500),” Pikashe says. “So, if things do not go well over the next five years – let’s say we have a major financial crisis, where your traditional equity products participate fully in that downside – the structured product would still have a floor. Its capital protection means that you can’t get out less than you put in.”
Liquidity and diversification
For financial advisors, structured products offer a very useful planning tool, especially if they are included as an allocation (some advisors recommend up to 25%) of the investor’s portfolio. “Some people make the mistake of looking at structured products as standalone products,” says Pikashe. “Instead, they should be seen as building blocks in a client’s portfolio. As a financial advisor, you can allocate to these products depending on your client’s risk profile, or you could use a combination of structured products. In terms of equity exposure, it makes sense to diversify geographically and into different sectors, but it also makes sense to diversify the pay-off you get from those equities. A structured product is a useful building block because it could have a different pay-off than the rest of the portfolio.”
In terms of geographic diversity, Absa’s range of offshore products includes rand products with FX exposure on the returns. “The rand tends to depreciate over time against major hard currencies like the dollar, so it makes a lot of sense to give clients a hedge against that by enhancing their returns if the rand does depreciate,” Pikashe says. “Our off-the-shelf offshore USD range includes a defensive product which gives 95% capital protection in US dollars, with upside participation in a global equity index. Typical investors are clients who are sitting in dollar cash looking for an alternative, or clients who do not want to risk their capital.”
Liquidity is another key factor. While structured products have set terms, investors can exit at any point. “If your financial situation changes and you need to exit, you can do so – and you do that at the mark to market value, or the fair market value of the underlying note based on its current market price,” says Pikashe. That could result in some capital loss – not through any exit fees, but rather because of the value of the note in the market at that given date.
A structured product is a useful building block because it could have a different pay-off than the rest of the portfolio
A trusted issuer and banking partner
Key to this all is understanding that structured notes are debt instruments issued by a bank. The credit risk is that of the issuer, which is why it’s so important that the investor is comfortable with the bank as the issuing entity.
“You need to be comfortable that the bank will be around for the next five years,” says Pikashe. “If you buy a structured note and the issuer goes insolvent, you’re going to lose some or all of your money. You are dependent on that issuer being able to fulfil its obligations in terms of the investment in five years’ time. That’s why credit risk and credit ratings are so important.”
To illustrate her point, Pikashe provides a comparison between buying the same structured product from a Tier 1 global bank versus a Tier 3 bank. “If there’s a difference in the credit rating between the two banks, you will see it in the terms on offer,” she says. “The Tier 3 bank will give you better terms because there’s a credit spread, so it’s cheaper for them to provide the capital protection and they therefore have more money to spend on the option. But while you may get better terms from the Tier 3 bank, you’ll be exposed to more risk because the bank doesn’t have the same credit risk as the Tier 1 bank.”
Absa, for the record, issues all its notes as senior unsecured debt instruments. This means that in the highly unlikely event that the bank was to experience some financial difficulties or even go out of business, the clients who hold the bank’s notes would have a higher likelihood of recovering some or all their capital compared to subordinate debt note holders.
Through its partnerships with major international investment banks, Absa can offer a full suite of solutions. And while it is the credit issuer for most of its structured products, the bank also provides clients with access to major international banks’ structured product offerings. “When you deal with Absa CIB you’re not just working with our products and innovations,” says Pikashe. “We give you access to the best of what’s available globally.”
Absa offers a range of structured solutions, with either defensive (conservative) or moderate (equity alternative) risk profiles. For more information, visit aiss.absa.co.za.
