Under the bonnet of structured products

Transparency is key for the success of structured products, writes Aviva Investors’ Robert Corbally

With interest rates still at record lows, it is understandable that some investors are on the lookout for more rewarding homes for their savings. Many will look to equity markets as a good alternative.

Advocates proclaim how cheap markets are and stress the longer-term outperformance of the asset class. However, with so much economic uncertainty still around and so soon after the bear market, few would believe that there is any guarantee equity markets will continue to rise.

Against this backdrop, there is interest in products with downside protection from people wanting to preserve their wealth and yet take some measured risk to boost potential returns above cash market rates. Structured products offer a form of capital protection and participation in any growth of equity markets.

Typically, at the moment, protection is offered as long as the stock market does not fall by more than 50% over the lifetime of the product – and there are no cases on record where the FTSE 100 index has fallen by that much over a five-year period. Meanwhile, generous pre-defined annual gains will be locked in if the market rises above its level on the date when the product is taken out.

This isn’t a new concept. The roots of the structured products market arguably lie with guaranteed bonds offered by life offices in the 1970s, although it is with the development of derivative markets that the structured products we see today began to take shape. However, the collapse of Lehman Brothers in 2008 exposed counterparty exposure as one of the main risks associated with the derivatives used in structured products and fundamentally altered how investors should look at these products.

Spreading counterparty risk

It is not just product providers who should consider counterparty risk. Individual investors themselves must also consider their exposure to a single counterparty. If they are a regular buyer of structured products, and they buy them all from the same provider and that provider always uses the same counterparty, the investor will become very exposed to the risk of that counterparty’s failure.

Just as a product provider should seek to spread their risk across a number of counterparties, an individual investor should also endeavour to spread a portfolio of structured products across different providers that each use different counterparties.

Investors may also limit counterparty risk by choosing product providers that require collateral to be put up against the value of the derivatives being used. Collateralisation works by making the counterparty lodge government bonds equal to the current market value of the derivative exposure in a separate account.

The value of bonds posted is adjusted daily. In the unlikely event of the counterparty’s failure, the bonds can be sold and the proceeds made available to the structured product investors. This mitigates against the risk of capital loss if a counterparty fails.

However, not all structured products afford the same transparency and so it can be hard to see which products are collateralised and which are not.