01 Sep 2008, Risk magazine
The past year has been one that Australia's structured product providers would rather forget. Global equity markets have tanked, causing a number of structured investments to knock out and stop paying coupons. If that wasn't enough, a change in the tax treatment of capital-protected equity loans - one of the most popular products among Australian investors - has caused that market to grind to a halt. Dealers say overall volumes have shrunk dramatically, with some reporting an 80% drop in business in June compared with the same month in 2007.
A large part of the existing travails can be traced back to the turmoil sweeping the global financial markets. Although the current crisis began in the US subprime mortgage sector, the fallout has rapidly spread across virtually all asset classes. Fears over the effects on the wider economy, along with burgeoning writedowns at investment banks, caused equity indexes to go into freefall in January, while equity implied volatility has soared on several occasions since the crisis cranked up a gear in August 2007. The Chicago Board Options Exchange's Vix index, which measures the market's expectation of 30-day volatility on Standard and Poor's (S&P) 500 index option prices, touched 30.83% on August 16, 2007, before dropping to 16.12% by October 9, 2007. The index subsequently spiked to 31.01% and 32.24% on 22 January and 17 March, respectively.
The Australian stock market has, to a large extent, mirrored the drops in US and European equity markets. The benchmark S&P ASX 200 index was trading at 4,969.14 on August 6, 2008 - a 16.97% drop from its August 7, 2007 level of 5,985.01. That is despite an up-tick late last year, which saw the index close at 6,339.836 on December 31.
That has made life tough for investors who had placed their cash in equity-linked structured products. In particular, structures incorporating downside barrier options have suffered, with many knocking out and paying no further coupon for the remaining life of the investment. Products employing constant proportion portfolio insurance (CPPI) have also performed poorly, with some cashing out - meaning investors are effectively invested in a zero-coupon bond and unable to benefit from any future equity market upside.
"As everywhere else in the world, there are a number of structured products that have come under stress as a result of the recent market meltdown, notably those with a downside put or a CPPI structure," says Paul Darwell, formerly head of equity derivatives Australia at Citi in Sydney, who retired in August. "As the market has dropped, many of these barriers have hit and the capital protection in CPPI structures has knocked in, meaning investors are not invested at all in the strategy."
One product to have been hit is the Alternative Listed Protected Securities (Alps) series offered by Macquarie. The bank launched six series of the product: Alps 1 to Alps 4 were referenced to baskets of between 64 and 80 stocks listed on the Australian Stock Exchange (ASX); while Alps 5 and Alps 6 were tied to a portfolio of 80 US securities listed on the New York Stock Exchange and Nasdaq. The return on each series was vulnerable to knock-out events, which occur when the price of any of the reference stocks falls below a predetermined barrier, either at a single point in time or on three consecutive trading days, depending on the series.
For instance, Alps series 6 offered a fixed payment of 12.5% in the first year. Investors subsequently received a maximum of 13.5% in year two, rising by up to 2% each year. However, the income payment reduces by one-seventh for every stock that falls by more than 45% of its initial value and closes below this level for three consecutive trading days. If seven knock-out events occur, the investor receives no more income payments for the remainder of the 7.5-year life of the product. And that is exactly what happened, with the final knock-out event occurring on June 24.
In fact, none of the six series of the Alps product now pay income, having all suffered knock-out events - although the product is capital protected at maturity, so buyers will get their initial principal back. The product is also listed on the ASX, so investors are able to close out their investment prior to the maturity date (albeit with no capital protection).
Those investors who instead opted for CPPI products have also got burned. "Many clients have not factored in the opportunity costs that come with CPPI structures. With the increasing number of deleverage events, this lesson is not being learned," remarks Suzanne Salter, head of structured investments at Commonwealth Bank of Australia (CBA) in Sydney.
CPPI works by dynamically rebalancing cash between risk-free assets (for instance, government bonds) and risky assets (such as equities), with the aim of ensuring the amount invested in fixed income is sufficient to repay 100% of the investor's principal at maturity.
When structuring a CPPI product, a floor is set below which the portfolio value is not allowed to fall, and the cushion (the portfolio value minus the floor) determines how much money is invested in equities to generate returns. The exposure to stocks varies as the portfolio value changes, so if the stock market falls, cash is pulled out of equities and a greater proportion is invested in fixed income to ensure the redemption amount is in line with that promised to the investor. If the portfolio value hits the floor - the minimum level required to provide the guarantee - the investor would effectively be left holding a zero-coupon bond for the remainder of the product's life.
Many investors had opted for these products as they appeared cheaper than those investments with embedded downside puts, explains Salter. "Protected loans are very expensive at the moment because the price of puts has increased so drastically, so if the interest rate on a CPPI product is much lower, investors often prefer that product to get exposure to the share market," she says. "They forget the fact that, if the stock market drops and later rebounds, an investor who is long the stock with a put option will benefit from that rebound, while a CPPI investor is left with only the minimum guaranteed cash."
Of course, it isn't just those who invested in structured products that have been hit by the drop in the market. Many have seen the value of their equity portfolios - and their superannuation funds - sink in line with drop in the index. The share prices of Australian banks, in particular, have been hit hard; and with these stocks considered the cornerstone of any equity portfolio, the effects have been widely felt. "Australian retail banks have always been considered relatively stable investments that have traditionally offered very attractive dividend yields," says one banker. "Australians certainly haven't had to hold a collateralised debt obligation in their portfolio to feel the pain from the credit crunch."
One factor unique to structured products, however, has been a change in the tax treatment of capital-protected equity loans - a move that has drastically reduced demand for these products. "In Australia, structured products are typically used to either provide leveraged or protected exposures to Australian equity markets, rather than the types of yield-enhanced trading strategies commonly seen in Asia or Europe," notes Kurt Jeston, division director at Macquarie Securities Group in Sydney.
Capital-protected equity loans allow investors to borrow a lump sum of cash, which can be used to buy stocks or other securities. The capital protection feature means investors are shielded if the value of the shares falls below the initial loan amount. As the investment is structured as a loan, investors can claim tax deductibility on the interest payments. However, the capital protection feature is not deemed tax deductible. In some cases, these products are structured with a separate put option, meaning the non-deductible capital protection cost is clearly identifiable. In others, the cost of the capital protection is more opaque, particularly in the case of products where the capital guarantee is provided by dynamic hedging or CPPI. In either case, the cost of capital protection is often embedded within an inflated interest rate charge.
Australian tax rules state that a certain component of the interest rate charge should be attributed to the cost of protection and therefore should not be deductible. Under previous rules, the Reserve Bank of Australia's (RBA's) benchmark indicator for personal unsecured loans (currently at 14.55%) was used to determine the capital component of capital-protected borrowings. However, this was changed in the 2008/2009 budget, announced in May, to the RBA's indicator variable rate for standard housing loans (currently 9.25%). The new rules state that interest expense on a capital-protected borrowing in excess of the 9.25% level will now be treated as the cost of capital protection and not deductible if on capital account - in effect, reducing the interest rate deduction available to investors.
The new law applies to any new product sold from May 13, 2008, although the old regulations will continue to apply for the life of any product purchased before this date or for five years, whichever is shorter.
The rule change has had a dramatic effect on capital-protected equity loans, causing new business to slow to a crawl. "This tax change increases the after-tax cost by 5%, meaning markets must increase by a further 5% compared to previous years before investors start making money. Given the fact that most investors currently see the skies falling around them, they are not going to be willing to invest in these products," comments Salter.
To top it all off, Australian banks - facing their own problems accessing funding - have upped their deposit-taking efforts and are offering investors guaranteed returns well above the RBA cash rate, which currently stands at 7.25% - a level the structured product industry is finding difficult to compete with. "For most structured products to offer attractive returns, equity markets have to do well," says Salter. "When markets are volatile and investor sentiment is poor, it is difficult to convince investors to make a three- to five-year investment with an unknown return, especially when bank deposits are offering 8.2%."
The situation looks dire for the structured products market, but dealers say there are positives that can be drawn. In particular, recent volatility has accentuated the benefits of capital protection. "With recent market volatility, capital protection has been valued by investors. On the one hand, you hope it won't be needed at maturity; but when you have experienced markets like these over the past 12 months, you're happy it is there," says Jeston of Macquarie.
Losses in the equity market could also drive investors to think more about diversifying their portfolios into alternative asset classes, argue some bankers. "Many Australians are well and truly overweight Australian equities relative to other asset classes, and that has proven to be a problem in recent months," says Mark Small, executive director of equity structured investments at UBS in Sydney. "Investors have always predominantly focused on the tax treatment of their investments; but after the recent market turmoil, I expect them to look much more at diversification of their portfolios."
This is already beginning to occur, with more investors willing to consider investments in interest rates, foreign exchange and commodities, notes Faye Hughes, vice-president, structured investor sales for fixed income, currencies and commodities at Citi in Sydney. "Local investors are now looking to broaden their product suite. They are beginning to look more at interest rate plays such as range accruals, along with foreign structures linked to Brazilian, Russian, Indian and Chinese currencies, for example. Similarly, we are seeing more interest in soft commodity trades," she says.
Citi recently launched a commodity-linked investment linked to the performance of the S&P GSCI Agriculture Index, targeted at Australian retail investors. The product is structured as a deferred purchase agreement and offers 100% capital protection at maturity. Investors can participate in the positive performance of the index, up to a predetermined barrier level. Once the index reaches this barrier - set at 130% of its initial value - the product terminates with a maximum return of 15.5%.
Dealers also report embryonic interest in hybrid structures that combine two or more asset classes. In particular, products that play on a theme - for instance, emerging markets - are beginning to grow in prominence. "Recently, investors utilising some of these strategies have seen the benefits that a hybrid structure can provide by combining non-correlated assets," observes Jeston.
Macquarie, for instance, launched its MQ Gateway series in April 2007, which allows customers to invest in a combination of ideas generated by Macquarie's research department, spanning emerging markets, currencies, agriculture, gold, the environment and property. The structures offer a choice of 90% or 100% capital protection at maturity (typically 3.75 years), and also include a floored average mechanism that locks in a proportion of growth on the underlying asset on a quarterly basis.
One such product combined a 50% exposure to the S&P GSCI agriculture sub-index, with the remainder referenced to the Market Vectors Agribusiness exchange-traded fund. "Many investors have seen the strong performance of hard commodities and energy markets over recent years. With soft commodities lagging these assets, but with record low inventory levels, many investors have seen this as an opportunity to diversify their investment portfolio away from industrial equities and property," notes Jeston. "Other themes within the MQ Gateway series that have been really popular include Asian financials and emerging markets infrastructure."
That is not to say investors have deserted the equity markets completely. With stock prices falling so far, particularly in the financial sector, some see this as the ideal time to buy. "You've got to find those people who do believe this is a good time to buy," says Salter of CBA. "We're focusing on offering shorter-term structured products that guarantee an attractive amount, but offer a bonus coupon if a certain condition is met - for example, petrol, a stock index or an exchange rate reaching a certain level - as well as strategies with which clients can make money in a volatile environment, such as by writing call options."
Even those products that have been the worst hit in the past few months, such as reverse convertibles, have seen some interest from investors who feel stock prices are unlikely to fall much further. In their simplest form, reverse convertibles pay an enhanced coupon so long as the reference stock does not fall below a certain barrier. If it does breach this level, the product would redeem in shares at the barrier strike.
For instance, Citi sold a reverse convertible referenced to Australian financials in July with a barrier of 60%. "There has been some bad news from Australian banks in recent weeks, but the barrier is reasonably soft and we're not anywhere near that level yet. And the rewards from selling the put option are around 40% per annum, which easily covers any dividend an investor might miss out on," says Shane Miller, vice-president of equity structured products at Citi in Sydney.
However, this is by no means widespread, with the majority of investors - certainly those in the retail sector - shying away from these products in the current environment. "We do have some sophisticated investors who are using reverse convertibles to set their buying level for stocks. However, most retail investors are still nervous," notes Salter.
Investors over the near term are likely to remain cautious, with greater demand for capital protection and diversification. Despite the difficult past few months, structured products are likely to be at the centre of this shift. "There are investors who do feel confident enough to take directional views, but most have become more defensive," says Miller. "Diversification strategies and relative value or outperformance trades, such as emerging markets or the Dow Jones Eurostoxx 50 versus the best of the Nikkei 225 and the S&P 500, have become a lot more popular."
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