Synthetic solutions still rule

They may be accused of being expensive and opaque, but structured products continue to be on an upward trend in Europe, in huge demand from both private and retail banking customers. One striking example comes for the Italian post office. During 2007, Poste Italiane sold to its mass affluent clientele structured bonds with a nominal value of €5.5bn, the large majority of which – over €5.3bn – was gathered into one product alone. The capital-guaranteed Reload BancoPosta was, in fact, created by the group’s banking services business unit, BancoPosta, and distributed through the countrywide network of 14,000 post offices. This sales story looks even more remarkable when examined against the background of Italy’s fund management industry, which has suffered more than its European ­counterparts. In 2007, Italian investors triggered an unprecedented outflow of fund assets, to the value of ?53bn in 2007 (mainly fixed income and equities), according to the country’s mutual funds ­association, Assogestioni.

Bond for security

Leveraging on the risk aversion of Italian retail investors, Poste Italiane will continue to rely on this particular structured bond for the year ahead, explains Massimo Sarmi, chief executive officer of the Poste Italiane group. “This instrument is very popular with both Poste’s sales network and its clients, who traditionally prefer to invest in a product that offers the security of capital guaranteed at maturity and the payment of a minimum guaranteed return,” says Mr Sarmi. In addition to regular fixed-interest coupons, the bond pays additional coupons linked to the ­performance of five international equity indices, both in the case of appreciation and partial depreciation (with a maximum level of -10 per cent). “This structure is particularly suitable in the current market scene, characterised by a general uncertainty on the possible market developments,” says Mr Sarmi. With structured bonds focusing on major fashionable investment themes, Poste tends to target more ­sophisticated clients. For 2008, the firm plans to ­distribute a product focusing on the consolidation of growth in some emerging markets, such as China, Eastern Europe, Turkey and South Africa, says Mr Sarmi.

Growing themes

Investing in sectors linked to the development of ­alternative energy sources – a theme already developed by the Italian firm with a product launched in spring 2007, one which has gathered over €150m – are also considered valid. Another investment theme with high potential could be represented by structures relying on the interest rate curve increase, says Mr Sarmi. The possibility to sell structured products at a fair price on a secondary market may offer important ­guarantees, which could help to dispel the not always good reputation that these products have. BancoPosta bonds are quoted on the regulated ­market MOT of Borsa Italiana; moreover, the presence of a Price Maker throughout the life of the security offers the daily possibility to all Poste’s clients to liquidate the bond at a “fair price” before maturity, explains Mr Sarmi. He also claims that the firm, which has been ­distributing structured bonds since the end of 1999, ­differentiates itself in relation to its Italian competitors because of its level of commission, which is between 30 and 50 per cent lower than the average in the market. Poste Italiane, continues Mr Sarmi, represents one of the very few companies on the Italian market which does not distribute its own securities and relies on third parties to cover the risk of the products it distributes. The firm contacts about 30 major investment banks on the international scene in any tender in order to find the best player for covering the risk of structured bonds. The key selection criteria are flexibility and availability to interact with Poste, in order to create products ­meeting clients’ needs. In the post-sales process, the care to contribute with continuity and with a fair price on the secondary market is what the firm looks for in its partners, says Mr Sarmi.

Products for private banks

Structured products have also been thriving with private banking investors. “We have seen a general increase in the use of structured products in client portfolios over a period of time,” states Brendan Whitely, head of ­product advisory at Credit Suisse’s private banking ­business in the UK. “It is really the flexibility and the variety of investment profiles and tailored customised solutions that you can deliver through structured ­products which is quite attractive to the ultra-high net-worth investor.” Indeed, customisation is what ­differentiates the approach of a private bank to the one-size-fits-all approach typical of the retail banking world, explains Mr Whitely. For the majority of the past year, equities have been the predominant driver in terms of investor appetite, says Mr Whitely. “The volatility we have overseen in the market since last summer presents its opportunity as well, in terms of selling the high-equity market volatility to lock in quite attractive coupons with significant ­protection on the downside.” Additionally, the price behaviour of underlying ­investments such as commodities can be quite volatile. “If you can achieve exposure to those markets in a risk-controlled manner, with some capital protection, you can provide the clients’ diversification in their ­portfolios in quite a risk-controlled manner, giving them a sleep-at-night factor.”

Having said that, it is quite impossible to generalise and identify an optimal asset allocation to structured products, says Mr Whitely. “In terms of advisory clients it really depends on the risk profile and what their investment objectives are; in terms of discretionary managed portfolios, we may see an allocation to the structured products space that may vary around the 10 per cent mark,” he says. In terms of themes for the year ahead Asia, perhaps not ­surprisingly, comes top. “Asian currencies are ­strengthening versus the US dollar and one way of ­playing that investment theme in a risk-controlled way would be to develop a structured product that was linked to a selected basket of Asian currencies, for example,” says Mr Whitely. “Another theme that we see is Asia real estate ­outperforming Western real estate markets. One could structure a product that plays the relative performance of one real estate market versus the other in various risk-controlled ways,” says Mr Whitely.

Commodities rising

The role that commodities play as the underlying ­investment in structured products is set to become even more ­important in the next few years, says Pierre Bes, head of European private banking coverage at Barclays Capital. Recent surveys indicate that private investors intend to allocate as much as 10 per cent of their ­portfolio into commodities over the next three years. This represents an average three-fold increase of today’s allocation, says Mr Bes, and a greater number of ­investment ­strategies and products will include exposure to ­commodities. “We see investors’ demand for ­diversification into various commodity assets,” he says. As an example, Barclays in 2007 launched the Barclays Global Carbon Index, whose performance has exceeded 25 per cent over the last six months, says Mr Bes.

Taking what’s on offer

Oil and gold are probably the most popular underlying components of structured products today, but there is also a growing interest in soft commodities, such as agricultural commodities, and some specific metals where there is a strong discrepancy between demand and offer, he says. Globalisation of the economy continues to create opportunities. Some economists see the share of gross domestic product in the OECD countries directly coming from international trading growing from 18 today to 30 per cent in 10 years. “There will be greater exchanges of goods and it will create opportunities in areas such as freight and shipping,” says Mr Bes, “where we have seen demand for indices such as the Baltic Dry Index (BDI).”

Barclays indeed recently launched products built on the BDI, the shipping and trade index created by the London-based Baltic Exchange, which reflects freight activity by measuring changes in the transport cost by sea of raw materials such as metals, grains and fossil fuels. Hybrid structures, where underlyings from different asset classes are blended together, also represent a ­significant development in structuring products.

“Investors are more and more opportunistic when they choose investment themes,” says Mr Bes. “Sometimes, to play the same story, they can use ­equities, ­commodities, foreign exchange, funds or even assets such as real estate or private equity.” It is becoming increasingly important for investment banks to provide investors with full access to all asset classes and the “unique” multi-asset class platform that Barclays Capital has developed today represents a strong advantage, states Mr Bes. “Flexibility to adapt to the investor’s view is critical, and often innovative products and strategies can be replicated over different asset classes.” Hybrids between equities and commodities playing a strong theme, such as food or agriculture or alternative energy, are very popular with European distributors. Barclays has also recently launched a range of products combining exposure to underlying equities and credit; the aim is to enhance the return on equities with some limited exposure to credit, explains Mr Bes.

“Credit spreads remain extremely high, which also creates a few opportunities for investors.” Barclays Capital has recently sold a structure called “credit ­equitybrium” to private banks, which combines a ­classic yield enhancement strategy linked to a small selection of blue chips stocks with a credit event in one of these companies. “The current levels of credit default swaps, even on blue chip companies, allow these strategies to provide a significant yield pick-up,” states Mr Bes. Hidden assets such as volatility and correlation still offer a good base for risk-neutral strategies. Barclays Capital’s Voltaire index, launched last year, takes ­advantage of structural imbalances in option pricings and generates returns from the differential between implied and realised volatility. The “implied volatility” reflects the market’s ­expectation about how much the price of an asset, such as a stock or an index, will change in the future, as the “realised volatility” quantifies the historical prices changes of an asset over time.

As Mr Bes adds, “This index is a cheap and simple way to profit from this ­arbitrage strategy, often used by hedge funds.” A growing demand for simple and transparent market-neutral strategies has driven the firm to launch a few indices and products over various asset classes in 2007, says Mr Bes. Donald Leitch, head of exotic derivatives structuring at Commerzbank, Corporates and Markets in London, anticipates that products linked to some general ­investment themes such as alternative energy linked to the climate change story will continue to be at the ­forefront of investors’ minds for the foreseeable future.

Ways of shaping up

However, as the result of the credit crunch seen over the last few months, there have been some notable short trends manifesting themselves, particularly in the structured product world, in the types of pay-off that people are trading and the underlyings they are linking to, says Mr Leitch. “Implied volatility on financial stocks has gone very high and subsequently we have been doing a lot of business in yield-enhancement products, such as reverse convertible, linked to particular American ­banking stocks,” says Mr Leitch.

“I think this is set to continue in the short term, but longer term, towards the middle of the year, when some kind of market normality returns, I would expect this particular theme to fade into the background,” Mr Leitch predicts optimistically. As a more general result of the credit crunch, higher implied volatility and expectations of further declining interest rates are shaping the way products are ­structured. “It gets much harder to do capital ­protected products, because options are very ­expensive, so I would perhaps expect to see a few more CPPIs ­(constant proportion portfolio insurance) for principle protection rather than using option-based products,” says Mr Leitch. Indeed, high volatility is a condition particularly favourable to structured products. And, by far, structured products are the most widely available and liquid instruments available for taking advantage of very high volatility. There are not any ­existing exchange traded funds that track volatility, and very few funds that track any kind of volatility ­strategy, says Mr Leitch. At the heart of a structured product, being it a note or a fund, there is an option or derivative of some sort, whose price is linked to volatility, he adds.

Ucits III convergence

Ucits III legislation, by enabling a much more flexible use of derivatives within a regulated fund, has driven the convergence between funds and traditional ­structured notes. It has enabled many more products that were previously sold as a structured note to be wrapped and distributed in a fund. “We have seen more interest in the structured funds than in the past,” says Mr Leitch. “In many markets the broad investor base is much more used to seeing funds as the kind of legal wrapper of choice, as the product they are familiar with and know the feel of.” If intermediaries and distributors are just comfortable with the mutual fund as the legal format of the product delivery vehicle, the fund also assures a higher degree of transparency than a note. “Obviously, a fund has certain obligations to its investors to obtain a certain minimum degree of service as regarded investments. So it provides an additional layer of investor protection, because there is a fiduciary duty on behalf of the fund director to act in the interest of the fund’s investors.” However, there are higher costs and longer lead times associated with funds. And private banks ­traditionally have very short lead times. “Private banks can phone up in the morning and want to trade products by the afternoon,” explains Mr Leitch. In the case of a large retail distributors, where the product development and launch cycle span over ­several weeks or even a few months, structuring and launching a structured fund within this time becomes perfectly feasible.