A little protection
Gloomy prospects for US financial markets this year have failed to suppress a buoyant structured products space. Issuance for 2007 has now been confirmed to have topped the $100 billion mark, as predicted by the US Structured Products Association, which represents a rise of almost 80% on last year's $64 billion.
The market's current shape remains similar to its embryonic beginnings in 2003, when issuance was a mere $28 billion, in that reverse convertibles still constitute the majority of products sold. Like a convertible bond, which gives the holder the right to convert the bond to equity in the future, reverse convertibles give the issuer the right to repay the holder in equity, with a typical tenor of three or six months. This has been the foundation for a wide variety of equity-linked payouts. JP Morgan, for example, has four such products on offer at the moment, linked to the common stock of four different US companies. The three-month notes pay a monthly coupon, but the repayment of principal at maturity is linked to the performance of the share in question. If the reference stock is at a lower value than its initial recorded price at the strike date, and has fallen below 30-40% of that figure during the life of the note, the investor can be repaid in those shares. The danger is that they could be worth considerably less than the initial investment, and investors risk losing their entire principal.
Reverse convertibles' domination of the market has come at the expense of principal-protected notes (PPNs), which at a generous estimate still represent only around only 20% of all products sold.
"In terms of issuance, the reverse convertible is definitely the most popular structure, accounting for around 65% of the total," says Philippe El-Asmar, New York-based head of investor solutions for the Americas at Barclays Capital. "In general, principal protection is only a small part of the space. About 75-80% of all the structured offerings in the US are not principal protected. (The market) is more geared towards equity investments where you get the full downside."
Recent market volatility could, however, provide PPNs with a chance to increase their market presence, as unpredictable equity markets make investors anxious about riskier products. According to El-Asmar, a big theme over coming months will be investors who are worried about preserving their capital.
Straightforward as this seems, PPNs still face a series of challenges if they are to achieve anything like the market penetration they have in Europe. The first obstacle is the traditional investment culture of US investors, which is heavily biased towards equity. "Typically speaking, a US investor is very comfortable picking equity risk. For example, many investors day-trade stocks for their personal accounts," explains El-Asmar. In Europe, however, there is much more of a fixed-income mentality, where the primary objective is to preserve capital, he says.
The difference is that European investors are happy to speculate with the fixed-income part of their portfolio whereas traditionally US investors are not. "European investors have been used to speculating with their fixed-income investments for years," says Tom Ricketts, Chicago-based chief executive of Incapital, which distributes structured products to 200 different brokers accessing retail markets. "They would buy a fixed-income product with a highly variable return, so essentially a PPN with a handful of factors that go into your real return," he says. "In the US, people speculate on stocks and they own funds, and they think of their principal-protected product as fixed income."
A lot of the growth in 2007 was driven by reverse convertibles, and their foundations were laid by covered calls, says Ricketts. "There are a lot of investors in the US who have traditionally done straight covered writes - they buy the stock, sell the call and harvest the income," he explains. "The reverse convertible is just a cleaner, simpler way of doing an interest-generating trade for the customer and it has been very popular."
Ricketts is bullish about growth prospects for PPNs as industry acceptance increases for the whole structured products space. Structuredinvestments.com, an educational resource for advisers run by Incapital, counted 14,000 unique users each month throughout the fourth quarter of 2007, a sign that awareness of structured products is on the increase. Ricketts says advisers are starting to recognise the number of exposures they can take on a principal-protected basis. "That is something I think they will increasingly offer clients to round out their portfolios," he says. "Undoubtedly, right now, interest is much higher in PPNs. This is logical given market volatility."
Volatility is certainly giving a boost to this sector of the structured products space as investors become more risk averse, or "risk aware", as Philippe Carrel, New York-based executive vice-president of Reuters Trade and Risk, describes it. The appetite for reverse convertibles will wane, says Carrel. "A reverse convertible is for an investor who is willing to accept quite a lot of exposure on the downside, and who has a bullish view but thinks that the market is likely to keep progressing moderately. That will not be flavour of the month at the moment," he says, adding that investors who are interested in high risk will return to hedge funds. "I think a capital-protected note with limited downside risk and which was properly hedged by the issuer would be a very sensible choice at the moment," he says.
However, it would be a mistake to assume that choppy markets have smoothed the way entirely for a European-style take-off in PPNs. In fact, market conditions could even work against this. The US marketplace is distinct from Europe in several ways.
A small but significant section of the market is occupied by certificate of deposit wrappers (CDs), which have been popular in retail channels. In the US, deposits come with Federal Deposit Insurance protection, which covers investors for up to $100,000 should the bank holding the deposit become insolvent. This has made them attractive among retail investors, but because of the recent 75 basis point federal interest rate cuts, it is becoming harder to price these products attractively. As Carrel says: "CDs will also experience problems due to the dramatic interest rate cut." It is a potential problem for structures across the board.
Concerns about tenor could be an equally troublesome barrier to wider PPN popularity. A characteristic of the US market is the appetite for short-tenor products, with most products issued having a term of less than two years. Reverse convertibles are ideal for this, but PPNs generally need to be held for longer. Given market conditions, investors have become even more uneasy about extending their exposure due to concern about risk.
"One trend we have seen over the past two to three months is that investors have shortened the tenor that they are willing to go out on," says Michael Clark, New York-based director of structured retail products at Credit Suisse.
"Looking at our distribution channels, PPN flow has traditionally been divided 50/50 between longer and shorter tenor products, but now typically 85% of our flow is two years or less," says Clark. This short-term trend is, he says, market driven and down to risk aversion. "A lot of that 85% has gone into one-year products, which were pricing up well until the recent Fed rate cut," he says. Clark emphasises, however, that "the long-term trend is towards capital protection, and is driven by the demographics of the US. As the population ages, people are less willing to risk capital."
The spectre of interest rate cuts is making it difficult to create appealing principal-protected structures, which means structurers are scaling protection down to push up coupons. This is more congruent with the traditionally ambivalent attitude to principal protection that US investors have had, and is seeing a raft of different levels of protection becoming available on the market.
"At Citi, we have got 100% principal-protected products, but I also expect we'll see products that offer 80% principal protection growing in popularity," says Barbara Mullaney, head of US structured products at Citi in New York. "Investors are sensitive to tenor and want shorter-duration deals, but in the interest rate environment that we are in you can't get terms that look good in a short-dated maturity." Mullaney concludes that since the end of last year people are simply looking for more protection, from 10% up to 100%.
Another option to increase coupons, rather than lengthening tenor, is to structure more exotic payouts into PPNs, but this contrasts with the usual vanilla, linear-style payouts that US investors are accustomed to from their equity investments.
"The US is much more vanilla in its product offering than Europe or Asia," says Joseph Elmlinger, New York-based head of global equity derivatives at Citi. "The average investor isn't using structured products to achieve highly exotic payoffs and returns." He puts this down to a long history of investing in individual stocks, combined with the accessibility of the listed options market to US investors, which by contrast is less liquid and less available to the average retail investor in other parts of the world.
The difficulty lies in persuading asset managers to incorporate these non-linear results into a portfolio. "It is a considerable challenge for investment advisers and portfolio managers to start including those types of payouts into their asset allocation models and assess the overall risk on a portfolio that includes non-linear products," Elmlinger says.
Unfortunately for PPNs, they also suffer from a tax status that can place them at a disadvantage. Clark explains the so-called phantom-income problem, which makes them inefficient in tax terms. "If you look at their construction, any PPN has a theoretical zero-coupon bond, with a call option for instance. The theoretical 'zero' is taxed on an accrual basis every year," he says. "You get a tax bill every year, even though you haven't received any income and the underlying could be down." Unfortunately, a further blow is dealt to the investor at maturity, when any gains are taxed at short-term capital gains rate - which can be as much as 35%.
The solution turns investors back again to shorter-tenor products, which lessen the phantom-income problem, although as Clark reiterates: "With rates so low and volatility so high, it is hard to make the economics work for shorter-dated capital-protected products." Payouts are becoming more exotic in nature to combat this effect, he concludes.
The evolution of the US' recession worries will have a serious impact on the development of PPNs in the structured products space. Unstable markets will undoubtedly continue to push investors towards protection. But any further rate cuts will make it even more difficult for structurers to price protected products attractively, and tempt investors away from the attractions of the short-tenor, equity-linked tradition.
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