Investing in a structured product

Technology has made investing via a structured product more accessible to the average retail investor.

Investing in a structured productWith the economic fallout expected from COVID-19, investors have either seen their portfolios seriously hurt or are too afraid to enter the equity market now. Sitting in cash is an option, but what if markets recover and investors lose out on potentially higher returns?

Investing via a structured product is one way to protect your capital but still have exposure to the stock market.

A structured product uses financial instruments to offer varying forms of capital protection to investors while also allowing them to benefit from any upside in the market. This is done by using a hybrid of a bond or deposits and an equity derivative – usually a call option. It’s important to mention here that investors do not hold these instruments directly. They are held by the bank that issues the structured product in order to deliver on the promise made by the structured product.

Listen to Maya and Mapalo Makhu discussing this topic in the My Money, My Lifestyle podcast.

Bonds are issued by both governments and corporations to raise capital. Banks also issue bonds for the purposes of investment products. On the maturity date, the issuer promises to return the value of the original investment amount plus a specific rate of interest.

As the interest is fixed, bonds can be used to provide a guaranteed return. For example, you want to invest R1 000 but you want to know that at the end of four years you are guaranteed to get your R1 000 capital back. The structured product provider would purchase a bond. If the bond is paying a 9% per annum interest rate, the product provider would use R700 to purchase the bond as the total return from the bond at the end of four years would be R700 capital and R300 interest, providing you with the R1 000 originally invested.

This leaves around R300 (excluding fees) which can be invested in the market to provide for a return. Rather than investing the R300 directly into shares, the product provider uses this to buy a derivative which gives the investor exposure to the asset at a fraction of the cost of the actual asset. A derivative is a financial security with a value derived from an underlying asset (such as a stock) or a group of assets (such as an index).

For example, full upside exposure of R1 000 initial investment to a market may cost only 10% (R100). In this example your R300 would give you 300% exposure to positive moves in that market – so 300% of the actual market return.

Catering to all risk appetites

Structured products can be created with many different outcomes. You could select one with higher capital protection but limited or capped upside (profit), or you could have a product that protects you against some market losses but because you are taking on some risk, there is opportunity to earn in excess of the actual index return.

There are many different types of “structuring” you can do in a structured product, so it can be tailored to the exact outcome you are trying to achieve or risk you are trying to mitigate.

But it is important to understand exactly how the product works and what it is offering.

So why have retail investors not heard more about structured products? Traditionally these products were only available to high-net-worth individuals who had millions to invest, and the structured products that were originally developed for the retail market lacked transparency and hid some seriously high fees. Access to the products is limited as they are not available on most investment platforms and financial advisers are not necessarily familiar enough with them.

Ryan Sydow, head of index and structured solutions at Absa, explains that with increased competition and advances in technology, at both issuer and investment-platform level, there is a growing understanding, awareness and adoption of structured products.

“They are no longer expensive and only for the very well heeled. Investors and advisers alike have woken up to the fact that markets do not always just go up and you need investments in your portfolio that perform when your traditional active or index-linked strategies are not.”

Japie Lubbe of Investec’s financial products team agrees. “The last six years have seen a surge in the number of structured products being issued, and clarity on pricing is one of the main factors for their increased popularity.

“While some structured products do still suffer from these issues, there is also now a set of offerings that are some of the most transparent investments available. The benefits to investors are numerous.”

Lubbe adds that structured products provide an excellent method to provide investment alternatives. A further benefit is that anyone buying into these products knows from the outset what the potential outcomes will be.

What you need to know

Your biggest risk is the issuer of the bond, as this is your guarantee. Make sure that whoever is issuing the bond, whether it is a government or corporate bond, is going to make good on the loan.

Sydow says you should also find out whether or not the bond is a ‘senior’ debt which means that you are a creditor at the top of the list should the corporate go insolvent. In the case of a bank, this usually means you will be paid after depositors but before other creditors.

Also be aware that you give up all your claim to dividends in the underlying index. The expected dividend yield is an input into determining what price you pay for the equity exposure you will get under the structured note. Considering that dividends are an important element of total return, that is an opportunity cost in return for a higher participation or guarantee. Your upside is completely based on capital return.

Offshore exposure with rand protection

Absa offers a wide range of structured product options, but what you need to keep in mind is that the return profile is largely determined by the price of the bond. The lower the interest paid by the bond issuer, the less money available to invest in the derivative, thereby reducing your market exposure.

Although Absa offers both local and offshore structured product options, Sydow says a good option for South African investors is to purchase the protection in rands but have growth exposure to offshore indices in hard currency like USD.

South Africa still has relatively high interest rates compared to the rest of the world which makes South African rand-based bonds more attractive to use in structured products. Absa uses its Absa corporate bonds as the underlying protection. Sydow says if you purchase the bond in rands, you will pay around R68 per R100 of protection. After a typical fees of R5 (in total i.e. R1 per annum), you will have R27 to purchase a call option on an index.

They employ this in their Global Growth Basket which is linked to a global equity index benchmarked against the MSCI World Index, where besides the ZAR capital protection, they give you at least 450% upside to the first 20% rise in those markets. That means from a mere 4% per annum in equity markets one could receive a 90% return in rands and even more if the rand has depreciated against the dollar over the five years. Your capital is 100% protected if you stay the course.

Absa structured investments are available for as little as a R10 000 investment; however, they are currently only available through an accredited financial adviser.

Low-risk returns on your offshore cash

Japie Lubbe of Investec’s financial products team believes structured products offer a solution to those with cash sitting in offshore bank accounts. While investors may be afraid to invest their money in the markets, interest rates in most developed economies are close to zero.

Investec’s new China Seas Basket offers market exposure with a 100% protection on the downside in USD. “The investment is ideal for investors who have a positive view on the market over three years, but who are conscious of the risks in the short term,” says Lubbe.

The investment is a three-year-and-10-month investment that references the Euronext CDP Environmental World Index, a globally recognised environmental, social and governance (ESG) index. The index includes a mix of mainly tech, financials, telcos and consumer staples, with a 52% Europe and 48% North America split. Investors achieve 110% of the upside returns of the index, with no upside cap over the period (in other words, if the index returns 20%, the investor’s return is 22%).

The principal protection is linked to Standard Bank, while the minimum investment US$10 000, or A$14 000. “As a dollar investment, the China Seas Basket could well suit investors holding dollars in an offshore account, currently at extremely low interest rates,” says Lubbe. The investment closes on 10 July.

Jargon

  • Maturity – the term of a structured product is typically between 3 and 5 years
  • Payoff profile – the defined return the investor receives at maturity, and the market conditions under which it is payable
  • Underlying asset – the note’s performance is linked to the price return (excluding dividends) of an asset, such as an equity index or stock basket, in a specified currency
  • Protection – the level of protection the investor receives if the underlying asset loses value

What is a call option?

Many structured products use a call option, which is a contract between the buyer and the seller of the call option to exchange a security at a set price on a future date. It is an option on the purchaser but not an obligation.

The easiest way to understand a call option is how it works on an individual share.

Example

The current share price of ABC company is R100 per share. You purchase a call option to buy that share at R110 in four years’ time. The price for that call option is R10. You buy 100 call options for R1 000 which gives you exposure to 100 shares in ABC. After four years, ABC is trading at R200 per share. You have the option to buy shares at R110 each, which means you can sell them immediately for R200 and make a profit. Your total purchase cost per share is R120 (R110 plus the R10 option fee), so R12 000 for 100 shares. You sell for R20 000, making R8 000 profit from a R1 000 investment. If, however, the share price has fallen to R90, you do not have to exercise your option. Your total cost, and therefore loss, is R1 000.

How much an investor pays for a call option depends on the future value you select, the expected dividends of that share and the current and expected volatility of the share. You can also cap the profit to lower the price of the call option, take some downside risk and increase your exposure.

This article first appeared in City Press.

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