Unpacking Investec’s latest offshore investment product: the China Seas Basket
I am normally not a big fan of structured products. Historically, these products have been expensive, with costs hidden from investors through creative pricing. Even as costs have become more transparent, it is questionable that an investor with a long-term investment horizon should be paying a heavy price for a guarantee they probably don’t need.
I am, however, intrigued by Investec’s latest structured product offering – the China Seas Basket. Firstly it is exposed to the two geographical areas that many fund managers are calling a buy, namely Europe and Japan; secondly, investors are receiving a reasonable gearing to the indices; and finally, it is cost effective when comparing to a direct investment into those indices.
The underlying China Seas Basket is made up of five indices (20% in each index), namely MSCI Taiwan Index, MSCI Singapore Index, Nikkei225, Hang Seng Index and the Eurostoxx 50.
These markets have relatively weak currencies at the moment and are not commodity producers but rather manufacturers of consumption goods and therefore benefit from lower commodity prices.
The product, which is priced in pounds (GBP), offers investors twice the growth of the basket of European and Asian indices to a maximum return of 40% in GBP over a 4.3-year investment period with 100% downside protection in GBP.
Market returns are all priced in pounds – so if the basket goes up by 10%, the investor receives twice the return in GBP. An investor can receive double the return to a maximum of 40% ‒ in other words, the basket would have to have returned 20% to reach the 40% maximum over the investment period.
If one assumes the maximum return of 40%, that would equate to 8.14% per year in GBP.
This investment is only for offshore funds so any rand devaluation would have to be calculated separately by the investor, but currently the forward exchange rate is pricing the sterling-rand exchange rate at R34/£ by 2020 when the product matures.
How the product works
To take a step back, a structured product that offers investors upside participation in a specific index, or basket of indices, while offering principal protection on the capital, does this through using a portion of the investors’ funds to purchase a bond that will repay the capital over the specific period. The remaining funds are then used to purchase an option on the specific index, providing exposure to that index.
The more money available to purchase the option, the higher the participation rate in the index. The problem with most offshore guaranteed products is that bond yields are so low that virtually all the investors’ capital has to be used to purchase the bond to guarantee the capital, leaving not much for participation in market returns.
However, in this case, the product is using an Investec PLC bond with yield of 5.3% ‒ this means that only around 66% of the investors’ capital is used to guarantee the capital, providing 33% to purchase the option.
This specific bond was issued in 2012 with the release of Basel III requirements when all banks had to increase their capital reserves and at a time when no one really wanted to touch bank debt due to the fall-out in credit markets post 2007/8.
Investec PLC (the London-listed entity) had to offer a very attractive rate to attract capital, and issued the bond at 9.65% which was a very attractive rate in GBP, as long as the bank did not go under. As credit markets have settled, the capital value of the bonds has risen, dropping the bond yield to around 5.3%, but still attractive in GBP and a sufficient yield to guarantee investor capital over a 4.3-year period.
There is no free lunch in the investment world and if the bond is offering a yield above the market, one can assume there is some risk. In fact the main risk with this investment product is that Investec PLC defaults on the bond. Fitch’s latest rating (27th October 2015 publication) with respect to Investec Bank PLC (IBP) includes the following key rating upgrades:
- IBP’s Long-term issuer default rating has been upgraded to BBB with a stable outlook, from BBB- stable outlook
- IBP subordinated debt has been upgraded to an investment grade rating of BBB- from BB+
This is above our local banks as well as the South African Investec Bank, which have credit ratings of BBB-, so from a South African perspective the risk is slightly less than our local bank bonds.
Moody’s has upgraded the subordinated debt rating of Investec Bank PLC (as at 2 February 2016) from Ba1 to Baa3 (the equivalent of Fitch BBB-). The bond is now rated as investment grade.
The downside of investing via a structured product is that you forfeit the dividends which are kept by the bank issuing the option. As foreign dividends are normally taxable, the after-tax effect of not receiving dividends is around 7% reduction in potential return. The gearing however makes up for this as you only need the basket to return 7% in order to make up the lost dividends as your total return would be 14% in GBP.
Who should invest?
This product would suit South Africans with cash sitting abroad. Many South Africans who have used their investment allowance are too nervous to invest in equities, rather leaving it to the depreciation of the rand to provide returns. For those investors, this could be an attractive alternative where there is a good chance of market upside while at least providing a capital guarantee should the markets collapse.
Even if you do not require the guarantee, the product is a cost-effective way to access these indices. To cover costs over the investment period, the initial once-off expense provision upfront fee is 1% (excluding adviser fees); then there is an annual product fee of 0.6%, and administration fees of 0.15% upfront and 0.135% per annum, bringing the total expense ratio to 1.35%. An adviser can charge an additional 2% up front and an annual fee of 0.6%.
Although the guarantee is only for an investment held to maturity, investors are able to trade out the investment, which listed on the Bermuda Stock Exchange, on a daily basis if they require the funds before that time. There is a 1.25% cost to selling and depending on the value of the underlying option, one could experience a capital loss before maturity. This product is therefore only suitable for an investor who can hold to maturity.
Minimum investment is AUD15 000 or £8 000 (around R185 000 at time of writing). The closing date for funds to be invested is 3 March 2016 and the maturity date is 10 July 2020.