What is a Structured Product?
- The popularity of structured investments has increased significantly in recent years, worldwide - and this growth looks set to continue as investors universally seek alternatives to traditional investment funds. In particular, and not least when stockmarket volatility is prevailing, many investors are now specifically looking for investment solutions that present enhanced investment scope with increased risk control.
- Structured investments provide investors with unique opportunities to invest in stockmarkets and asset classes with the benefit of pre-defined risk and returns potential. Since the early 1990’s, structured investments have evolved rapidly and are now widely recognised as mainstream investment solutions by many investors. Growth in the use of structured investments has been exceptionally strong worldwide - Industry estimates put retail sales at £3 billion in 2013* (*citywire.co.uk 23/01/2014).
- Investing with the benefit of defined investment risk and returns potential clearly empathises with the interests of many investors. Especially during periods of stockmarket uncertainty or volatility, structured investments can quantify and specifically state the levels and types of investment risk that may apply to an investor’s capital and/or investment returns - providing innovative and compelling investment solutions, as alternatives or compliments to traditional investment funds. However a key risk borne by investors in structured investments is ‘counterparty risk’.
Why invest in a Structured Product through WealthMe?
- WealthMe is one of the leading Structured Product brokers and providers of independent research.
- Market leading discountsOur market position means that we are able to offer our clients some of the best discounts available on charges, making it cheaper to invest with us than going via a Restricted or an Independent Financial Adviser (IFA).
- We only charge a 0.4% arrangement fee for all the Structured Products we offer.
A Structured Product is usually a fixed term ‘investment’ or ‘deposit’ which is generally linked to the performance of a stock market index or indices. It tends to contain a certain guarantee of capital protection if certain investment criteria are met, and a formula-based return.
A Structured Product allows the investor to potentially benefit from the performance of an asset, without actually owning the asset itself. For example a structured product may provide a percentage of the return in the FTSE 100 Index without having to buy the shares, or hold units in a conventional unit trust. Where a traditional unit trust will buy stocks and shares in order to provide a return to its investors, a structured product will buy derivatives (or options) to take advantage of stock market movements without being exposed to ownership of the equities themselves.
Structured Deposits are term deposits (like a fixed rate bond) with variable return linked to the performance of an underlying asset (like the UK stock market).They can be held within a variety of tax wrappers such as a Cash ISAs, SIPPs and Bonds. They are designed to repay the initial deposit at maturity and at the same time deliver a target level of growth or income dependent on the option chosen. Therefore the aim of the Structured Deposit is to offer the investor a pre-defined fixed level of return (linked to a basket of shares) if held to maturity with 100% capital protection and at a coupon rate often well in excess of bank and building society accounts.
The majority of Structured Products are linked to the performance of the FTSE 100, although it is possible to find a few other asset links and performance is generally based on pure capital index performance.
Soft / Hard Protection
Hard protection means a fixed level of protection regardless of asset class performance. With soft protection, the protection falls away if the asset value breaks a given barrier.
Structured Products often involve three parties – A product provider, an out sourced administrator and a supplier of the underlying derivative-based investment (the Counterparty). The capital protection and growth / income defined under the terms of the Structured Product will be dependent upon the solvency of the counterparty. The counterparty is usually a bank and if it fails, the Structured Product could become worthless.
The formula-based returns of Structured Products often use more than just an Index reading at the start and end of the term. The final reading is often averaged over 6 or 12 months. This means last minute crashes are dampened. However, in theory it will also mean more often than not a lower final reading than if there was no averaging.
Some Structured Products offer considerable gearing (borrowing). High gearing normally comes at the cost of soft rather than hard protection, but can be attractive if market performance is only modestly upwards.
Counterparties are the institutions that provide, or issue, the financial instruments that deliver the investment returns of structured investments. As such, counterparties are critical within structured investments.
The counterparty institutions are responsible for any capital protection, growth or income features of the structured product. At its most basic, the simple fact is that structured investments depend entirely upon their Counterparty – in particular, their solvency throughout the investment term.
Counterparties must meet the contractual terms of the bonds that they issue – and their ability to do so largely depends upon their solvency. The risk that they might fail to meet the terms of their bonds is known as ‘Counterparty risk’, sometimes also referred to as ‘credit risk’.
A Counterparty failure during the investment term of a structured investment Plan, for instance through insolvency, such as bankruptcy, administration or liquidation, is likely to cause a ‘default’, ie the Counterparty will fail to make the payments due during the investment term and/or to repay their debts, ie the bonds, at maturity.
Usually the risk of a major financial institution failing to be able to meet its commitments in this way can be considered small - but a default or failure puts a structured investment, and any growth or income potential it provides, at risk - so the risk must be understood by investors.
Credit Ratings are a recognised indicator of the financial strength of an institution. Credit ratings are assigned by Credit Rating Agencies (CRAs), and the three leading CRAs, designated as Nationally Registered Statistical Rating Organisations (NRSRO’s) by the US Securities and Exchange Commission (the SEC) are Standard and Poor’s, Moody’s and Fitch Ratings.
Ratings are normally in the form of letter designations, such as AAA, A+, BB, C, etc. These provide investors in the debt securities of these institutions, such as a bond, with an indication of the institutions strength and ability to meet its obligations in repaying both the principal capital and any income due from the security.
Structured Investments are not risk free - but they do generally define risk, usually quantifying and specifically stating the levels and types of any risk(s) that may apply to capital and/or returns. However, a key risk borne by investors, with regard to structured investments, especially capital protected structured investments, is counterparty risk. Counterparty default can directly lead to a structured investment failing to deliver its stated returns at maturity. Counterparty risk specifically refers to the risk of the underlying issuer of the financial instruments backing a structured investment defaulting on its obligations during the investment term, or at maturity. The credit rating is a widely accepted measure of this risk.
A brief overview of each agency and the ratings designations utilised by each is provided on the following sections. It should be noted that credit ratings are agency opinions of an issuer’s overall financial capacity (its credit worthiness) to meet its financial commitments – but in the context of structured investments credit ratings do not apply to any specific financial obligation. It is also worth highlighting that Credit Rating Agencies are not infallible - and indeed have come under regulatory scrutiny and general criticism recently. A credit rating is not, therefore, a recommendation to purchase, sell, or hold a financial obligation, and a rating is not a comment on, or implied suitability of, any particular Plan, for any particular investor.
Standard & Poor’s (S&P) is perhaps the most well known Credit Rating Agency (through its US-based S&P 500 Index, etc). S&P dates back to 1860, when Henry Poor published information about the financial and operational state of U.S. railroad companies. The company as it is known today was formed in 1941 with the merger of Poor’s Publishing and Standard Statistics. In 1966 S&P was acquired by The McGraw-Hill Companies, which now encompasses the Financial Services division that publishes financial research and analysis on stocks and bonds.
S&P Rating Designations
S&P issues both short-term and long-term credit ratings, rating institutions/bonds on a scale from AAA to D. Intermediate ratings are also offered at each level between AA and CCC (i.e., AA+, AA-, A+, BBB+, etc) to show relative standing within the major categories (+ indicates the higher end of the rating category, - represents the lower). S&P also offers guidance (termed a ‘credit watch’) as to whether an institution/debt obligation is likely to be upgraded (positive), is (stable) or is likely to be downgraded (negative).
|AAA||The highest rating assigned by Standard & Poor’s. The capacity to meet financial commitments is extremely strong (the world’s major companies and governments).|
|AA||Differs from AAA only to a small degree. The capacity to meet financial commitments is very strong.|
|A||Rated ‘A’ means somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than higher-rated categories. However, the capacity to meet financial commitments is still strong.|
|BBB||BBB exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to meet financial commitments.|
Moody’s Corporation is the holding company for Moody’s Investors Service which performs financial research and analysis on government and commercial entities. Moody’s was founded in 1909 by John Moody who, similar to Henry Poor, offered investors an analysis of security values through publishing a book that analyzed the railroads and their outstanding securities. Moody’s claims that it was the first to rate public market securities. In 1913, Moody expanded his base of analyzed companies, launching his evaluation of industrial companies and utilities and ‘Moody’s ratings’ become a factor in the bond market. On July 1, 1914, Moody’s Investors Service was incorporated..
Moody’s Rating Designations
Moody’s issues both short-term and long-term credit ratings, rating institutions/bonds on a scale from Aaa to Caa. Intermediate ratings are also offered at each level between Aa and Caa (i.e., Aa3, Aa2, Aa1, Baa3, Baa1, Caa2, etc) to show relative standing within the major categories. 2 indicates a midrange ranking; 3 indicates the lower end of the generic rating category.
|Aaa||Judged to be of the highest quality, with minimal credit risk.|
|Aa||Judged to be of high quality and subject to very low credit risk.|
|A||Considered upper-medium grade and subject to low credit risk|
|Baa||Subject to moderate credit risk, considered medium-grade and as such may possess certain speculative characteristics.|
Fitch Ratings is a part of the Fitch Group. The firm was founded by John Fitch on December 24, 1913 in New York City as the Fitch Publishing Company. Fitch is the smallest of the ‘big three’ NRSRO’s, covering a smaller share of the market than S&P and Moody’s, although it has grown with acquisitions and frequently positions itself as a ‘tie-breaker ’when the other two agencies have ratings similar, but not equal, in scale.
Fitch Rating Designations
Fitch issues both short-term and long-term credit ratings, rating institutions/ bonds on a scale from AAA to D. Intermediate ratings are also offered at each level between AAA and CCC (i.e., AA+, AA-, A+, BBB-, etc) to show relative standing within the major categories. (+ indicates the higher end of the rating category, - represents the lower). Fitch also offers guidance (termed a ‘rating outlook’) as to whether an institution/debt obligation is likely to be upgraded (positive), is (stable) or may be downgraded (negative). The ‘credit watch’ positive/negative guidance indicates that a rating may be raised (positive) or lowered (negative) in the short to medium term – circa 6 months to 2 years – although it is not necessarily a precursor to a ratings change.
- AAA The highest credit quality, denotes the lowest expectation of credit risk. Assigned only in the case of exceptionally strong capacity for payment of financial commitments, highly unlikely to be adversely affected by foreseeable events.
- AA Very high credit quality, denotes expectation of very low credit risk. Indicates very strong capacity for payment of financial commitments, not significantly vulnerable to foreseeable events.
- A High credit quality, denotes expectations of low credit risk. The capacity for payment of financial commitments is considered strong, but may be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings.
- BBB Good credit quality, indicates that there are currently expectations of low credit risk. The capacity for payment of financial commitments is considered adequate but adverse changes in circumstances and economic conditions are more likely to impair this capacity. This is the lowest investment grade category.
Credit Rating Agencies assign ratings based upon views of ‘worst possibilities’ in the ‘visible’ future, as opposed to the past record or the present status of the institution/bond. Long term are therefore a reflection/appraisal of the long-term financial outlook and credit risks for institutions, as assessed by the Rating Agencies.
The table below highlights the differences and similarities in the credit rating symbols of the three main Credit Rating Agencies – detailing the long term rating scales for investment grade debt.
|Standard and Poor’s||Moody’s||Fitch Ratings|
In addition to noting the obvious (but sometimes confused) differences between the different credit rating agencies and their symbols it is also important to note that even institutions with the same credit rating from the same rating agency do not present absolutely equal credit strength/risk. In a broad sense institutions might be alike in their financial position, but as there are only a limited number of rating designations available, for use in grading thousands of risks, the symbols cannot reflect the numerous shadings of risk that actually exist.
It is possible that counterparty arrangements can change during the offer period of a Plan - and independent providers retain the flexibility to respond to events during an offer period (including credit events) through not disclosing the name of the institution, maintaining the ability to link a Plan to new counterparties.
The brand guidelines of some financial institutions may mean some insist they are not disclosed as the counterparty, or overtly linked to the marketing of a Plan.
EU Prospectus Disclosure rules have been interpreted by some institutions as preventing disclosure of counterparties in Plan literature.There are a number of structured products in the market place at any one time and we review all with the help of a number of specialist companies. However, as a company we have decided not to recommend any product that has a counterparty with a lower S&P rating of AA- at the same time the product is being offered. We will still consider other products with a lower counterparty only if the product structure is an attractive proposition.
Financial Services Compensation Scheme (FSCS) rules apply to the insolvency of an Account Manager, but do not normally apply in the case of counterparty default, ie counterparty insolvency.
The amount of tax you pay and value of any reliefs will depend on individual circumstances and the tax wrapper in which you invest. By investing directly into structured products (not via an ISA or an ISA transfer) you may be liable for Income Tax at your marginal rates or Capital Gains Tax at 18% or 28% currently. If the latter, any gains can be offset against your individual allowance). By investing within structured products via pension plans such as SIPP and SSAS schemes, any returns will be free of tax within such pension arrangements.
If you invest via an ISA all investment returns from your plan are currently free of income tax and capital gains tax. You can invest your full allowance .Existing ISA holdings can be transferred into these products also. All transferred accounts will remain sheltered from any income or capital gains tax.
Structured products is the name given to a category of tailor-made investments generally composed of several elements or component parts, each providing a specific exposure or protection for the investor. The sum of these elements creates a tailored investment that is not easily replicated by the individual investor. A structured product can be defined as a security which is constructed by combining bond-like elements and financial options. The end result of this combination is an investment product that is generally characterized by:
- Some form of capital protection, which is provided by the bond or bond-like element. This bond, referred to as the zero-coupon bond promises to pay the holder back some or all of the original investment (dependent on the level of capital protection selected)
- Defined return outcomes at maturity, provided by the financial option. The option is a financial instrument that pays a pre-defined amount, either a fixed amount or an amount calculated by reference to the change in an underlying asset, for example the FTSE 100 Index or a combination of stocks or indices. For this reason options are also called derivatives, as their value is derived from the underlying asset.
- Restricted liquidity (or ability to buy and sell freely), as the zero-coupon and option when combined together by an issuer into a security are normally not traded on an exchange. This means that structured products can in practice only be sold back to the issuer.
Structured products are therefore an expedient way to get exposure to equity and other market types (e.g. interest rates, commodities, exchange rates or inflation) whilst controlling risk, because the returns are clearly defined. For example, investors who wish to gain from growth in stock markets, but who are worried about their investment losing value when the market falls, can buy a structured product that gives some of the upside returns of the stock market, without the risk of losing their investment in a stock market downturn.
Other investors may wish to take more risk in order to get higher returns, and may choose a structured product with partial, or conditional, capital protection. It is important to realize that the capital protection of a structured product is dependent on two factors: holding the investment until its maturity (the end of the investment term), and the credit-worthiness of the issuer, or of the entity that guarantees the issuer.
Structured products can greatly assist in the diversification of an investment portfolio by giving access to a wider range of markets or asset classes. Typically, certain investments, such as hedge funds, commodities or emerging markets, are not easily available to individual investors as direct investments, or not suitable for direct investment. Structured products can therefore provide an effective way to invest, thus diversifying an investor’s portfolio.