Increasing investor choice
Equity investors have had the luxury of a range of indices from such providers as FTSE, Standard & Poor’s and MSCI for a long time. This has led to a wealth of products for investors such as principal protected equity products, exchange-traded funds (ETFs), futures and index trackers. In fixed income, and specifically in credit – often referred to as corporate bonds – there are a multitude of indices on offer from a range of banks, but until now there has been a dearth of tradeable products based on these indices. Index products give investors the confidence that they will receive broad market performance without worrying about paying exaggerated costs to a fund manager for stock selection. Actively managed funds will still form the majority of most investors’ portfolios, but passive funds – based on indices – still have a role to play in terms of reducing costs and adding diversification. Recently, a number of banks have started to provide solutions based on their indices and gradually these are becoming better understood and more popular. Many of these products will only form the building blocks that will provide tailor-made or broad financial solutions, but it is important to understand the kind of products that are coming to market. The first form of instrument to hit the market is the so-called “pass through” structure. Here a bank will buy a series of bonds, say 30, and repackage them into a single product. Morgan Stanley pioneered this structure, called “tracers”. The benefit of such a structure is that it enables investors to gain exposure to a larger number of companies than they may have been able to have by buying real corporate bonds. However the choice of bonds is made by the product provider, and isn’t rule-based. The cash flows that come in will also be based on the coupons paid on the individual bonds which might not suit all investors. Similarly, a range of index products has sprung up based on credit derivatives. Credit derivatives are the most recent and cleanest way of taking credit exposure. These products, such as the iBoxx 50 from ABN Amro and JECI from JPMorgan, offer exposure to the broad credit market in a single bond-like instrument. In each case the names are chosen according to rules, but the number of names differs: ABN Amro has 50 names in its product and JPMorgan 100. These products are simple, having regular coupons like bonds, and benefitting from the extra yield earned on credit derivatives over plain vanilla corporate bonds, known as the CDS basis. The attractiveness of these products means that other banks are interested in selling them. The simple structure of these products means that they can form the building blocks of other products, such as principal protected notes, and fund-based structures. The final area is that of index-linked swaps and notes. They differ from the products already discussed in that they have unknown cash flows, as the final coupon is paid out based on the change in an underlying index. In the case of Deutsche Bank’s Cristals, the index is the iBoxx Overall Index, an index of the corporate bonds of some 200 companies. The price and returns of this index are determined by the individual bond prices provided by the seven banks in the iBoxx consortium. All of these banks are also allowed to trade the Cristals product, but as this requires complicated systems and sophisticated trading and hedging methodologies, only Deutsche is currently doing this. The relative complexity also leads to higher transaction costs. The typical bid-offer spread on such products is 0.5 per cent of face value, compared with around 0.15 per cent for the others. While the banks vie to be the next FTSE, S&P or MSCI, investors are becoming spoilt for choice in the variety of products they can buy to gain more diversification and cheaper exposure to credit.
