Trade of the month: Defensive products

Defensive products have grown in popularity in recent years as investors seek products which pay good returns at controlled risk and those which are suited to range-bound markets.

One of the products reviewed this month is a defensive autocallable linked to the FTSE 100 Index. If the index is above 90% at the end of any year after two years have passed, the product will call with a payment of 9% for every year of its life. This investment has a greater chance of calling than a standard autocall because the strike is lower than the usual 100% level. Therefore, the coupon paid in the event of calling is lower than would be received for a standard construction. Because of the low strike, the product cannot be called in year one as this is a likely outcome and therefore would be too expensive.

The chance of the product not being called is reduced and therefore the product is lower risk although if no calling occurs then the downside risk is the same as would be the case for a standard autocall. In the event of the barrier being breached, the investment would lose 1% for each 1% that the index finishes below the initial level.

Another variation of this idea is a decreasing series of target levels. An example of this might be 100% in year one, 90% in year two, 80% in year three and so forth. This would offer similar risk reduction and would make calling in later years more likely because the target level gets progressively lower and therefore easier to reach.

The defensive mechanism can also be used for reverse convertibles by measuring any downside loss from a lower strike level, such as 90%. This would also be risk-reducing and therefore pay a lower coupon than for a product with at-the-money strike.

Digital products that pay a fixed amount if the index is above a target level can also use this idea by paying if the index is higher than a level set at somewhere below the initial level. Here the digital payment amount would not be as high as one requiring the index to be above the initial level.

In the US market, many accelerated tracker type investments feature a buffer of say 10% as hard protection meaning that losses only occur below the 90% level. This is often preferred to soft protection, such as a barrier which, although boasting an optically more attractive amount of protection, will be lost if the index falls below this level.

Defensive products allow the investor to keep a product linked to a well-known or benchmark underlying and the use of a buffer mechanism means that the index can fall a small amount and a successful outcome still achieved. In volatile and uncertain markets, where an investor is backing an index to be above, at or nearly at its initial level, it is logical to allow a small margin of decline. Where an index finishes at 99% of its initial value, the investor's view is essentially correct, yet a standard target level product would not pay out because the at-the-money target is missed. A defensive product, in contrast, allows a small amount of index decline and therefore has an obvious rationale.