Structured products can offer significant benefits to investors looking for certainty, guarantees and even enhanced returns. But they are not without risks and should not be used without a solid understanding of the risks that come with the rewards.
Before recommending a structured product to an investor, advisors must be sure the product is suitable and aligns with the investor’s investment strategy. The investor’s life stage, income requirements, need to access capital and risk capacity and tolerance should all be considered.
Who can benefit from a structured product?
Investors who should consider structured products are those who want:
- More certainty about the capital invested, as these products can provide a full or partial capital guarantee;
- More certainty of returns as the set pay-off profiles provide a predefined outcome;
- To earn returns that are geared or enhanced relative to the returns of an investment directly into the market;
- To diversify into pay-off profiles that differ from those of long-only investments; and
- To tailor an investment to a specified risk level.
Risks that should be considered
Every structured product needs to be evaluated for the risks they present to investors. The following checklist may be useful:
• Credit risk
Structured notes are issued with guarantees on investors’ capital, but the guarantee is only as good as the bank or insurer that issued the note. Investors’ capital is held on banks’ or insurers’ balance sheets. If the bank or insurer involved falters, investors, like all that entity’s other creditors, may lose capital.
South African banks issue some structured notes themselves and also offer those issued by international investment banks.
Most structured products are issued by banks with good credit ratings, but investors and their advisors need to check the ratings before they invest. Investors who purchased structured notes with capital guarantees issued by US bank, Lehman Brothers, for example, lost billions when that bank went bankrupt in 2008 despite its A-rating from credit ratings agencies. Structured products were out of favour for many years after 2008, but have recently enjoyed a comeback.
The regulation of banks and credit ratings has improved since then, but investors and their advisors need to be familiar with the creditworthiness of the institution providing the different elements of the structured product as well as the kind of debt the notes are issued as.
Internationally, banks are rated from tier 1 for large significant global banks to tier 3 for small local banks. Larger banks will have a better credit rating but lower-tier banks will be able to offer capital protection at a cheaper rate. The credit ratings of the issuer, the guarantor and the option provider should all be checked because banks that issue notes may obtain the instrument that provides the guarantee from another provider and the derivative that provides the return from yet another provider. These providers may have lower credit ratings than the issuing bank or insurer.
Investors and their advisors should also be comfortable with the credentials of the custodian that will settle the notes and the jurisdiction where it’s listed.
• Debt levels
Banks can issue their notes either as senior debt or subordinate debt. A note issued as senior secured debt is the safest as holders of this debt will be paid first if the bank gets into financial difficulty.
Most structured products are issued as senior unsecured debt, which is next in line for payment.
Below this is subordinate debt, followed by equity. Credit-linked structured notes are typically linked to subordinate debt.
• Liquidity
Investors must be aware of investment terms and risks of cashing in early if they are unable to stay invested for the full term.
As there is not much demand for structured products, if an investor wants to redeem before maturity, the issuing institution will typically unwind instruments in listed products and provide their market value after fees.
If the investment needs to be unwound, investors will receive the prevailing market value of the investment, which may be below the capital amount invested. The bond that provides the guarantee on maturity may yield less than the full capital if it is cashed in early and the derivatives may be in or out the money at any time before maturity. The JSE requires that banks publish the daily redemption rate for their products listed on the exchange. Some products return capital after a predefined period but then allow no further redemptions.
• The pay-off profile
Before investing it is important to understand the pay-off profiles, the conditions and how these are combined with any guarantees.
Some pay-off profiles can be difficult to assess as they involve complex trade-offs of returns and guarantees that interact in ways which are not always fully appreciated.
The pay-off on some products are based on the worst performing of more than one asset or an average of the assets.
For example, Nedbank has an auto-call product with the pay-off based on the worst performing of three different offshore indices. The product also pays out if in any year during the term all three indices are above the performance hurdle.
Combined with a partial guarantee on capital that sees investors participate fully in the losses if the worst-performing index falls below the barrier, the trade-offs are hard to assess.
The method used to calculate the performance of the underlying asset, index or benchmark to which the returns are linked, the participation rate and the calculation of any guaranteed capital must be clearly understood.
While many products compare the change in the index or linked asset at the beginning and end of the term, others do so at points during the life of the investment and may include conditions that consider the highest level of the index or asset during the term or the number of days the index or assets was above a certain level.
• Foreign exchange risk
If an investor invests in a structured product issued by a foreign bank in a foreign currency, movements in the rate of the rand relative to that currency could make a profit or a loss. These products may therefore provide good diversification or introduce a foreign exchange risk. Structured notes listed on the JSE are inward listed products and rand-denominated even if they are linked to foreign indices or assets, and investors are promised the pay-off or capital back in rands.
• Market risk
Structured products are linked to a reference asset such as an index, exposing investors to market risks – markets can go up, down or remain flat. Although many structured products include capital guarantees, some only offer partial guarantees that leave investors exposed to extreme market conditions – such as when the market falls more than 30% or 50%.
• Opportunity cost
A direct investment in the underlying index or basket of securities may outperform the pay-off provided by a structured product especially if there is a cap on the participation in returns.
Structured products do not pay dividends and pay-offs are based on the price index and not the total return index which includes dividends on the securities in the index or portfolio to which the pay-off is linked.
Dividends in South Africa make up a significant portion of the return – the 30-year track record shows dividends contribute 25% of the return of the All Share Index versus 20% for the S&P500. If the pay-off relative to the index is geared, the investor may be compensated for the loss of dividends.
There are no performance tables showing how these products have performed relative to direct investments.
Francois Strydom, portfolio manager at Momentum Securities, believes an investor with a 20-year investment horizon should only use a structured product with an exceptionally high coupon or very good gearing.
• Interest rate risk
Changes in interest rates may decrease (or increase) the product’s value during the term and affect investors who want to redeem early. The interest rate changes are important if you want to sell before the product has matured.
If an investor is invested in a five-year structured note that includes a bond and an option and interest rates come down aggressively, then the investor will be in the money on that bond component. The option is more sensitive to the underlying instrument’s movements closer to maturity.
The converse is true if an investor wants to redeem early after rates increase – they probably won’t get out what they invested because the price of the bond will have dropped.
• Fees
There are no standard ways of reporting the costs of structured products and profits made by the issuer may be built into the product with little transparency.
The issuer can make a profit through the participation rate or the terms of the coupon.
Depending on whether or not the product is listed and what the listing requirements are, margins and other embedded fees may or may not be disclosed. Investors and their advisors should consider pay-offs net of all fees, including product fees, distribution fees and platform fees.
• Tax
When an investor invests directly into a listed structured note, they are responsible for the tax.
The payout the investor receives from the product may be regarded as capital and subject to capital gains tax if the investor holds for the full period, which is typically more than three years.
Coupons, however, may be taxed as income, at the investor’s marginal tax rate.
The South African Revenue Service (SARS) may also deem the investment to be income if it appears the investor was trading securities or redeems before the investment term. Offshore notes held directly may be taxed as foreign dividends, interest or capital gains, depending on the note.
In an endowment product, the tax is withheld and paid by the life insurer and the proceeds will be paid to the investor net of tax.
