The Bonus Pool

Warnings of the financial toxic waste in the German financial system have passed the country's relatively sophisticated retail structured products market by. A few tweaks and some lowering of coupons and barriers still leaves enough product to satisfy retail hunger. Richard Jory reports from SP Deutschland in Frankfurt

If in doubt, buy a bonus certificate. While the broader financial markets toy with the waves of volatility and a distinct lack of liquidity, Germany's structured products market drives on relentlessly. And the flavour of the day remains bonus certificates, products that pay out a bonus at maturity if the price of the underlying asset has not dropped to, or below a price threshold during the term.

It does not stop there. This mature market, one of the most sophisticated in Europe with some of the savviest retail investors, is about to benefit from the reunification of a sellside community that was previously divided by allegiance to either of two trade associations. As of February 14, 2008, there is one association in Germany, the Deutsche Derivate Verbindung (DDV), which has already loaded itself up with the task of lobbying the European Commission.

Hartmut Knuppel, chief executive and managing director of the DDV, kicked off Structured Products Deutschland reminding the audience of the status of Germany's certificate market as the biggest market for structured products in Germany. Following with a plug for the benefits of trade associations - comparing the merits of self-regulation to the restrictions of state regulation - Knuppel delved into the response posted by the DDV to the European Commission's Call for Evidence on structured products.

Declaring the DDV as the body in Germany that has the understanding of the certificates market and also the need for transparency, Knuppel went into some detail about the enlarged lobby that includes the Austrian, Swiss, Italian as well as the German structured products trade association. The four associations have filed their response to the Commission's Call for Evidence. Knuppel noted the advantages of a collective of trade associations as providing a stronger voice in Brussels.

The second task for the DDV is to investigate the potential for rating structured products. The theme was taken up on the morning of the second day of the conference by Lutz Johanning, a professor at the WHU-Otto Bisheim School of Management. The rating of certificates would provide a solution to the understanding and transparency of structured products, said Knuppel. Noting the 300,000 products in the German market, Knuppel said that he would prefer an approach that clustered products within specific categories.

Johanning offered a slide that included five risk categories into which he would expect products to fall under the ratings model he explained. The scheme differentiates investors by risk appetite, from risk averse to speculative and the criteria judged include risk, information, liquidity, costs and fees. Johanning suggested a system that rates products on the basis of classifying the products with zero to five stars following the principle of suitability of the respective product for the investor.

An analysis of product information would be judged on an assessment of the marketing material and term sheets; liquidity would be assessed on the availability of trading within a to-be-defined bid-ask spread; cost includes those hidden within the structure; and a quantitative evaluation of the probability of failure of the respective issuer. The application of a similar approach for structured funds was also mooted, which would make sense.

Other than a taste for bonus certificates, panellists on the champagne roundtable at the end of the first day suggested that there are no new issuance trends in the German market other than for products linked to commodities, notably agricultural. Market talk has been dominated by the capital gains source tax, which will be introduced in January 2009.

Panellist Thomas Gerald Foth, Dusseldorf-based managing director at Columbus Finance, said exchange-traded funds (ETFs) have become more interesting, with the regular caveat that the margins are unattractive for independent financial advisers in retail distribution.

Popular products were outlined by Jan Brotzmann, associate director of structured investor products for Germany/Austria at RBS Global Banking & Markets, who spoke about products for uncertain markets, adding a footnote: "How economists always get it wrong".

Based on an analysis relying on the RBS euro-area slump indicator, which concludes that recession risk, though rising, is still very low at around 10%, Brotzmann outlined absolute-return strategies and the bank's turn of the month (Tom) strategy, which is based on the bias that above average equity returns are clustered around the end of the month.

"At the start of 2007, investors were increasingly concerned that equity markets were overdue a correction and/or bear market following the long bull-run since March 2003," said Brotzmann. "Consequently, investors were becoming more interested in products that attempted to produce absolute returns regardless of the market direction. We therefore predict that alpha-generating, absolute return-based products will play an important role in the future structured products space."

The RBS Tom phenomenon is extracted by splitting the Dax index into the Tom period, which reflects the performance of the index during the last and first few trading days in each month, and the non-Tom period, reflecting the performance during the middle of each month. Exposure is gained in the Tom period starting four business days before and three days after the end of the month by going long the Dax in this period. "This yields a profitable strategy with an IRR of approximately 14.2% and an annualised return of just 13.9% over the last 10 years," said Brotzmann.

During the non-Tom period, the Tom Synergy Fund will have no exposure to the Dax, instead funds are invested in money markets at the euro overnight deposit rate (minus a spread).

Where the Dax scores highly is in the indexes it has produced for emerging markets, especially Russia, said Hartmut Graf, head of issuer and data analytics at Deutsche Borse. According to Graf's analysis, the Daxglobal Russia Index has returned 40.4% over the seven years between September 2001 and March 2008, way ahead of its closest rivals and streets ahead of the majority of the competition.

BNP Paribas rolled out a presentation that included a series of products designed to cope with current volatile markets, before noting the importance of issuer ratings. Christine Dillinger, head for Germany/Austria of the Privalto arm of BNP Paribas' equity derivatives team defined the bank's mission as one designed to combat insecurity over market development, timing problems, high volatility and a high correlation between specific asset classes and also within asset classes. "These are perfect conditions for structured products and reasonable innovations," said Dillinger.

Partial protection is on offer with enhancements to the barrier observation of established discount and bonus certificates, said Dillinger, who explained a discount certificate with a 70% barrier that was only active at the end of the one-year maturity and offered a yield of 7%, and a one-year multi-capped bonus certificate on the DJ EuroStoxx 50, S&P and Nikkei indexes includes a 60% barrier and yielding 7.5%.

Other enhancements have been made to the entry point - for which BNP touted its Best Entry Express and Best Entry Bonus - and to the pay-off probability, which has driven innovation in the establishing of the Best Trigger Express. The product uses a stock basket that includes Commerzbank, Lufthansa and the perennial favourite Daimler, with the nest performer responsible for the premature payment and the bonus payment. The bonus is at 11%, 22% and 33% for the respective shares, with a 50% barrier only active at the end of the period.

Distributors at the conference said that their investors were interested even in single-stock products, and were relatively immune to the reduced yields on offer that have been put in place to allow a loosening of barriers, a topic that was the subject of much debate in the Interactive Business Networking session. "We just keep lowering the coupons and also the barriers," said one distributor.