A Guide To Retail Structured Products A Guide To Retail Structured Products
StructuredProductReview.com is designed to give IFAs a better perspective of the structured product market. Launched in 2009, it helps thousands of financial services professionals with their research into structured products. With weekly updates and new product alerts, IFAs are kept up to date with the latest product launches and the site gives users the key information on each product in a clear and concise format, also providing access to product literature and a product archive stretching back to 2000. StructuredProductReview.com is also dedicated to improving knowledge about structured products and houses an extensive archive of educational material with a range of bespoke articles from leading figures in the industry. The website is maintained by Lowes Financial Management, an Independent Financial Adviser with a forty-year pedigree and one of the country’s first adviser firms to achieve the “Chartered Financial Planners” accreditation. Structured products began appearing in the UK retail investment market in the early 1990s and we first came to prominence in this market in 2000 when we published a leaflet entitled “The Truth Behind Those High Yield Stockmarket Bonds” which warned against those that we felt were potentially misleading and providing insufficient reward in return for the risk. The first article warning of the dangers of what later became known as “precipice bonds” was published in October 2000 and was as a direct result of the Lowes leaflet. We also created an online review service that was widely used by IFAs and investors, helping them to identify some of the better value investments and highlight those that we felt should be avoided. As well as running StructuredProductReview.com we frequently contribute to the media and are often the first point of contact for the press looking for unbiased and objective comment.
Ian H Lowes Managing Director of Lowes Financial Management & Founder of StructuredProductReview.com
Contents Introduction 4 Structured Deposits 5 Structured Capital ‘Protected’ Products 6 Structured Capital-at-Risk Products 7
Product Types 8 Growth 8 Income 10 Auto-call / Kick-Out 12
Capital Protection Barriers 14
Plan Manager / Deposit Taker / Issuer
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Collateralisation
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Ways to Invest 21
Tax Treatment 17
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Introduction We define a structured product as, ‘An investment backed by a significant counterparty (or counterparties) where the returns are defined by reference to a defined underlying measurement (such as the FTSE 100) and delivered at a defined date (or dates)’. A ‘capital-at-risk’ structured product might for example offer a return of 65% on the investment if the FTSE 100 is at the same level or higher on the day the product matures in 5 years’ time. If the FTSE 100 is below that level, it will return the invested capital, unless it is more than a specified amount below, say 50%, whereupon capital would be reduced by the equivalent fall in the FTSE 100. We have been using such investments in our client portfolios (and our own) since the early nineties and while past performance is not a reliable indicator of future performance, they have helped to enhance portfolio returns while at the same time providing protection against stockmarket falls. We believe that structured products offer many attractive features which can be used to satisfy a variety of investor needs. However, we do not believe they should be seen as a replacement but as a complement to traditional investments such as funds. One of the possible outcomes of structured investments is that they simply return the invested capital at maturity. This inherent capital preservation feature would be welcome in adverse market conditions. However, the effects of inflation potentially eroding the real value of the capital should not be overlooked. Most structured products may be sold during the term but they are designed to be held until their maturity. If sold early, the investor may get back less than they invested, even if the underlying asset has performed well. These investments should therefore only be considered if the intention is to hold them for the full investment term.
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In extreme circumstances such as a bank failure some of these investments could result in the investor losing some or all of the money they invest. It is essential that, as with any investment, the product literature and terms and conditions are carefully considered to ensure that the investor understands the risks involved before investing. There are many types of structured products and in this guide we will look at the most common categories issued in the UK. These are structured deposits, structured capital ‘protected’ products and structured capital-at-risk products (the latter two are referred to collectively as structured investment products).
Structured Deposits As the name suggests, structured deposits are essentially fixed-term deposit accounts where, instead of interest being earned at a set or variable rate, the return is fixed but depends on the performance of the underlying asset, such as the FTSE 100. So, for example, a deposit plan might offer 20% return on the capital after 3 years as long as at the end of the investment term, the FTSE 100 is at or above the level at which the investment started. While nothing is completely risk free, structured deposits are designed to return investors’ original capital as a minimum at maturity. As with most UK deposit accounts, structured deposits usually include the potential benefit of protection should the deposit taker become insolvent during the investment term. This protection is provided by the Financial Services Compensation Scheme (FSCS) and UK eligible claimants have a right to claim up to £85,000 per individual per institution in such circumstances. The availability of such compensation is, however, dependent upon the investor’s eligibility as defined under the terms of the FSCS.
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Structured Capital ’Protected’ Products Structured capital ‘protected’ products are like structured deposits in that they are designed to return the original capital at maturity as a minimum. However, like structured capital-at-risk products (see page 7), they are often structured as loans to a bank or other financial institution. The returns outlined for any structured capital ‘protected’ plan, including the return of capital, are dependent upon the issuing institution, which may not be the Plan Manager of the product, remaining financially solvent for the full product term. The issuing institution is usually a major bank. In the most extreme circumstance of the issuing institution being declared bankrupt and/or being unable to meet its liabilities, investors may lose all of their original capital investment. It is important to understand that unlike structured deposits, where there may be potential recourse to the Financial Services Compensation Scheme for institutional default, there is no such provision for structured capital ‘protected’ or capital-at-risk products.
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Structured Capital-at-Risk Products Structured capital-at-risk products have defined risk and reward features. This means that as well as the reward of potential returns, there is the risk that the capital invested can be lost in adverse market conditions. As with other structured products there are pre-defined outcomes depending on how the underlying asset has performed at the end of the investment term. These investments, because they include risk of loss of capital due to market movements will, more often than not, offer a potentially higher return than products like structured deposits, which offer greater protection of the investment capital. The investor is potentially being paid a premium for taking the greater risk. Nevertheless, many capital-at-risk products will protect capital unless there is a large fall in the markets. For example, some products will only reduce the capital returned if the FTSE 100 falls by more than 50%. Capital return is, therefore, dependent upon movement in the underlying asset and the extent of any protection barrier. Also, rather than being deposits, like structured capital ‘protected’ products, structured capital-at-risk products most often take the form of loans to banks or other financial institutions. The returns outlined for any structured capital-at-risk plan, including the return of capital, are therefore dependent upon the issuing institution remaining financially solvent for the full product term. Likewise they do not have the benefit of the Financial Services Compensation Scheme in the event of the insolvency of the issuing institution.
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Product Types There are several types of structured product, which may prove suitable for different investment requirements.
Growth An investment designed to provide growth, which can be a fixed return dependent on underlying asset performance over the investment term, or geared participation in the same performance. ‘Geared participation’ means that an investor potentially receives a gain of a multiple of any rise in the underlying measurement. Participation rates for products linked to the FTSE 100 have, for example, varied between 0.5 times any rise (more likely to be seen on structured deposits) up to over 8 times any rise. Participation in an index is often capped at a maximum return of the invested capital and some plans also offer a minimum return. For example, a plan may offer 5 times any rise in the FTSE 100 over 5 years, capped at 75% maximum gain. If the FTSE 100 rises by 5%, an investor would receive 25% growth, in addition to their original capital. If the FTSE 100 rose by 16%, the investor would receive the maximum 75% growth in addition to their invested capital. Please note that most structured products do not include any return or reinvestment of dividend income that would arise if the investment was made directly in the underlying shares in an equity or other yield bearing index. Example http://www.StructuredProductReview.com/Growth Note that this plan has been randomly selected and may not be appropriate for your clients.
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Example of a FTSE 100 linked capital-at-risk growth plan with a 50% ‘End of Term Only’ barrier.
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Income An investment typically designed to provide income, payable monthly, quarterly or annually. Some plans pay income gross, so please ensure you are aware of the tax implications of any plan that you recommend (see page 17 for more information on the tax treatment of structured products). Income can be unconditional (payable irrespective of how the underlying assets perform), or conditional. A conditional income payment means that the investor would only receive income if the underlying asset meets certain criteria, such as staying above or below a certain level. If these criteria are broken, some or all of the future income payments could be lost dependent on the future performance of the underlying asset. Example http://www.StructuredProductReview.com/Income Note that this plan has been randomly selected and may not be appropriate for your clients.
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Example of a FTSE 100 linked capital-at-risk unconditional income plan with a 50% ‘Full Term Intra-Day’ barrier.
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Auto-Call / Kick-Out An investment that may have a maximum term of, say, 6 years but has the potential to come to an end and pay out a set amount on specific anniversary dates, depending on the terms of the product. The most common example of this would be if the underlying asset (for example the FTSE 100) is at or above its initial level 1 year after the start date, the plan would mature, returning investors’ original capital in full and the set payment for one year. If these criteria are not met, the plan continues until the next anniversary date and the same criteria are checked. This continues until either the plan ‘kicks-out’ or it reaches the end of the investment term. For example, a product might have a 6-year term and offer a gain of 10% after 1 year if the FTSE 100 is at or above the start level of the investment. So, if the investment is based on the FTSE 100 at a starting level of 5800, if at the first anniversary the level is at or above 5800, the product comes to an end giving the investor a 10% return. If the FTSE 100 is below 5800 at that point, the investment continues and at the second anniversary, if the FTSE 100 is at or above 5800 the investment matures giving the investor a 20% return. This continues each year, adding 10% per year until the end of the six years. At that point if the FTSE 100 is at or above 5800 the investor receives a 60% gain on their original capital, being 6 times 10%. These plans are often capital-at-risk products which means they protect capital from losses due to falls in the underlying asset only to a certain point. In the example above, the plan might protect capital, i.e. will return it in full, unless the FTSE 100 is lower on every anniversary and is 50% below the starting level of the investment on the final anniversary. If it is below that level, then like many other investments that do not protect capital at all, the investor will lose money – this is usually at a 1% loss of capital for every 1% the underlying asset is below the start level. Example http://www.StructuredProductReview.com/AutoCall Note that this plan has been randomly selected and may not be appropriate for your clients. 12
Example of a FSTE 100 linked, capital-at-risk, auto-call / kick-out plan with a 50% ‘End of Term Only’ barrier
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Capital Protection Barriers One of the major benefits of structured products can be the degree of protection to capital that they can provide during adverse market conditions. Structured deposits and capital ‘protected’ plans offer a return of the original investment in full regardless of market conditions unless, in the case of the latter, the issuing institution fails or defaults. Most capital-at-risk products offer some protection to capital against all but the most extreme market conditions. However, all protection is subject to the ongoing solvency of the issuing institution.
There are three main barrier types that apply to capital-at-risk products:
Full Term Intra-Day These plans aim to return the original investment at maturity unless the underlying asset falls below the initial level by more than the specified percentage at any point during the investment term, at which point the barrier is said to have been breached. These barriers are technically referred to as ‘American’ barriers. For example: a product with a 40% full term ‘Intra-Day’ barrier aims to return capital in full at maturity provided that the underlying measurement does not fall by 40% of the initial level at any point during the investment term. If, however, this level is breached during the term, the investment could still produce a gain if it recovers to above the initial level by maturity. If not, it is the final index measurement that will dictate the extent of any capital reduction.
Full Term Daily Close Many plans feature barriers which, rather than using full Intra-Day barrier observations, are observed on the closing daily level of the underlying asset for the full product term. This may seem a negligible difference but in volatile market conditions daily movements in many asset classes can be extreme.
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End of Term Only These plans aim to return the original investment at maturity, provided that the final level of the measurement is not below the initial level by more than the specified percentage known as the barrier level. For example: a 50% End of Term Only Barrier will return the investor’s capital in full at maturity as long as the final level taken at the end of the investment term is no more than 50% below the initial level. If it is below that level then capital will be reduced, in the vast majority of instances, directly in line with the fall in the underlying asset. The barrier is only observed at maturity. These barriers are technically referred to as ‘European’ barriers.
How do European (End of Term) and American (Full Term) barriers work? This hypothetical product strikes at an index level of 6000, matures at an index level of 5464 (-8.9%), and the 50% barrier would be breached if the index fell below 3000.
European barrier assessed at the end of product term. Return = 100%
8000 7000 6000
Index Strike level 6000
50% Barrier Barrier Breached at index level of 3000
Final index level 5464
5000 4000 3000 2000
2520
Lowest index point during term of plan
1000 0 American barrier assessed daily through the term of the plan. Return = 91.1%
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Dual or Multi Index Products While many of the structured products in the market use the FTSE 100 as the index against which they benchmark to derive their returns (the defined underlying measurement), there are some that link the returns to more than one index. Dual index structured products will typically offer a higher potential return than those based on a single index because the risk of achieving no return, the risk of a loss arising and, or, the extent of any loss is dictated by the worst performing index. The higher potential return is therefore in keeping with the relatively higher risk, when compared with a structured product based on a single index. The most common pairing of indices is the FTSE 100 and the S&P 500. These indices include the blue chip companies in the UK and the US and are usually paired because they have a relatively close correlation, thereby increasing the probability that they will move in the same way in given market conditions. It is possible to pair any set of indices (or to use three or more indices in a product) as well as to design products that use the listed price of individual stocks as the defined underlying measurement. Products can, for example, use groups of five or ten of the major stocks in the FTSE 100 as the benchmark that determine the returns.
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Tax Treatment If a structured product is held directly, i.e. outside a tax shelter such as an ISA, it will usually be subject to tax. Most growth, auto-call / kick out and growth with auto-call plans are designed such that a UK retail investor will incur a potential Capital Gains Tax liability at maturity. This can prove to be very favourable as every individual has an annual capital gains exemption (£11,000 for the 2014/2015 tax year). Any losses will usually be able to be netted against gains for the tax year in which they fall. Any gains that fall outside of the annual exemption in the year of maturity will be subject to tax at the prevailing rate, which for the 2014/2015 tax year is 18% for basic rate taxpayers and 28% for higher rate taxpayers. Income plans are normally, but not always, subject to Income Tax. Income may be distributed gross or net of basic rate tax depending on the plan. However, income payments will usually be subject to UK income tax at the investor’s highest marginal rate. If income is paid net of basic rate income tax, higher rate tax payers will be subject to a further liability via self assessment, which should be declared to HMRC.
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Plan Manager / Deposit Taker Many structured products will have a Plan Manager. This company will be an FCA regulated firm responsible for a variety of duties including the design, packaging and distribution of the products. Most importantly, they have a fiduciary responsibility over the plan after the investment has been made. All post-sale communications will be issued by the Plan Manager. It is important to understand that the Plan Manager of the product may not necessarily be linked in any way with the organisation providing the assets which underpin the product itself. All structured deposits have a deposit taker which will hold the deposit. The return of capital will be dependent upon the continued solvency of the deposit taker throughout the term of the investment. In the case of the deposit taker becoming insolvent, eligible claimants in a structured deposit may have a right to claim up to £85,000 per investor, per institution from the Financial Services Compensation Scheme (FSCS).
Counterparty / Issuer As we have already identified, most structured investment products will be structured as a loan to a major financial institution. Like any loan, there is a risk that the borrower may not be able to meet its financial obligations and fall into insolvency. Investors must be aware that unlike deposit based products, structured investment plans do not benefit from FSCS cover if the issuing financial institution goes bankrupt. It is of paramount importance, therefore, that investors understand the risks of placing their money with the issuing institution. Credit ratings provide the most recognised barometer for assessing institutional creditworthiness. Standard & Poor’s long-term credit ratings range from ‘D’ to ‘AAA’ where, for example, ‘CC’ indicates that the financial institution is currently highly vulnerable in terms of its financial commitments, and ‘AAA’ denotes that the financial institution has ‘extremely strong capacity to meet its financial commitments’. These ratings may be modified by the addition of a ‘+’ or ‘-’ sign to show relative standing within the major rating categories.
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Similarly, Moody’s long-term credit ratings range from ‘C’ to ‘Aaa’ where, for example, ‘Baa’ infers that the financial institution’s obligations are judged to be subject to moderate credit risk, are considered medium grade and may have speculative features, and ‘Aaa’ which infers that the financial institution’s obligations are judged to be of the highest quality, with minimal credit risk. Moody’s ratings also include numerical modifiers ‘1’, ‘2’ and ‘3’, where ‘1’ indicates the higher end of its generic rating category and ‘3’ indicates the lower end. The ratings of the issuing institution for each plan are displayed on StructuredProductReview.com Credit ratings are the most common form of credit assessment and are used by investors of all levels of financial sophistication. However, it is important to realise that they are not completely infallible and ratings agencies struggled to stay ahead of the curve during the major financial crises of the past few years. No matter how unlikely the collapse of a major counterparty may seem, it is not impossible and we do not believe that any bank could survive a ‘run’ without external support. You should therefore consider the implications that the resulting loss would have for the investor should the counterparty fail and diversify their portfolios appropriately.
Long-term Ratings Standard & Poor’s
Moody’s
Fitch
AAA
Aaa
AAA
AA+, AA, AA-
Aa1, Aa2, Aa3
AA+, AA, AA-
A+, A, A-
A1, A2, A3
A+, A, A-
BBB+, BBB, BBB-
Baa1, Baa2, Baa3
BBB+, BBB, BBB-
BB+, BB, BB-
Ba1, Ba2, Ba3
BB+, BB, BB-
B+, B, B-
B1, B2, B3
B+, B, B-
CCC+, CCC, CCC-
Caa1, Caa2, Caa3
CCC+, CCC, CCC-
CC
Ca
CC
C
C
C
RD
-
D
D
-
-
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Collateralisation To mitigate counterparty risk, some plans are collateralised - this is where the money raised by the issuing institution is not held on its own balance sheet but invested into collateral assets. The collateral itself can be varied in nature but is normally made of securities such as government bonds (gilts), cash or loan obligations of other financial institutions. The collateral is held by a separate custodian and the value is normally adjusted daily to match the value of the plan. Returns on collateralised products will tend to be lower than similar non-collateralised alternatives. Now, however, some product providers have started to introduce new styles of collateralised plans where the credit risk of the investment is spread across multiple issuers/ institutions. These plans can benefit from lower costs than traditional collateralised alternatives and mitigate the problem of single issuer risk. Whilst diversification of risk is a much vaunted investment principle, it is important to understand that material credit risks remain with these plans. In the event of an issuing institution of a collateralised product becoming insolvent, an enforced early maturity is likely to occur which could result in a return of less than the invested capital.
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Ways To Invest Investments can be made in several different ways, the most common of which are listed below:
Direct Investment A ‘direct investment’ refers to holding the investment outside of a taxsheltered wrapper such as an ISA or SIPP. Thus, any returns generated by direct investments may be subject to tax as detailed in the plan’s individual terms and conditions.
ISA Investments held within ISAs (Individual Savings Account) are sheltered from Income Tax and Capital Gains Tax. ISAs are available in two forms: Cash ISAs and Stocks & Shares ISAs, which are described below.
Cash ISA Cash ISAs do not expose the capital to risk other than in exceptional circumstances. You can usually only make an investment within a Cash ISA for a structured deposit.
Stocks & Shares ISA Stocks & Shares ISAs expose your capital to risk and are therefore different to Cash ISAs as you can invest into funds, bonds, shares and/or structured investments. Cash can also be held pending future investment in a Stocks & Shares ISA, however interest earned on the cash held in this component will be subject to a flat 20% tax charge.
(N)ISA From 6th April 2014 to 1st July 2014, the ISA allowance for the 2014/2015 tax year was £11,880, which could be split between a Cash ISA (maximum £5,940 per year) and a Stocks and Shares ISA. From 1st July 2014, the “New ISA” allowance has an overall subscription limit of £15,000, which can be invested fully into a Cash ISA, Stocks and Shares ISA or a combination of both to total £15,000.
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ISA Transfer Most structured products can accept the transfer of existing Cash ISAs or Stocks & Shares ISAs (depending on the product type) from a different provider whilst retaining the tax sheltered status on those funds and without affecting current year ISA subscription allowances. Exit charges may apply from the existing provider. Cash ISAs can be transferred to a Stocks and Shares ISA and, from 1st July 2014, can subsequently be transferred back into a Cash ISA.
SIPP Many structured investment products can be held in a Self Invested Personal Pension (SIPP) subject to the rules of the pension provider / individual scheme.
Wraps / Platforms A number of traditional investment platforms offer access to some structured products. However, the costs at up to 0.65% per annum are often prohibitive, particularly as these platforms provide little information about the investment and do little more than facilitate the holding of all of an individual’s investments in one place.
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What’s with the Giraffe? Giraffe stand head and shoulders above most creatures and, as such, have a unique vantage point which fits very well with our intention to provide you with a better perspective of the structured product market. We felt that we did not just want to use its image as our logo without giving something back and we therefore decided that it would be a fitting use of some of our resources to support its conservation. The Rothchild’s Giraffe Project is therefore one of our chosen charities. Rothschild Giraffe were once abundant in Kenya, Uganda and Sudan but as a result of poaching, human-wildlife conflict and habitat encroachment they are now confined to parts of Kenya and one park in Uganda. With less than 670 individuals left in the wild they are listed as Endangered and under threat of extinction in the wild. The Rothschild’s Giraffe Project was founded in 2009 to conduct vital scientific surveys of behaviour, ecology and social structure to provide research and information to enable the development of conservation plans in collaboration with governments and wildlife managers. It relies entirely upon charitable donations and without such support they would be unable to operate. If you have benefitted from using the website, or even just found our giraffe advertisements endearing, please visit www.girafferesearch.com and maybe consider making a donation - please let us know if you do.
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