Structured products a way to smooth market jitters

Structured products were hit hard by the fallout from the financial crisis. Volumes fell dramatically as many investors viewed them with distrust, while increased regulation created numerous challenges for manufacturers. Low interest rates have also had a huge impact, as the capital protection products that were very much in vogue became unaffordable. 

But recent events in China, Greece and elsewhere have brought turbulence to stockmarkets and many see structured products as having an important role to play in client portfolios.

“Since the beginning of August we have seen much more volatility in the markets, which means better conditions for the vast majority of the products being used on the wealth management side,” says Jérémie Vuillard, group head advisory, at Société Générale Private Banking Hambros.

Current conditions make it attractive for launching new products, but most clients are looking at those already on the market as many are trading at a discounted price, he says. Those with features that can enhance prospective returns are proving most popular. 

Structured products can be built to access a particular risk return profile in a way that cannot be done with traditional asset classes. “That is why they should be bespoke rather than off-the-shelf,” says Mr Vuillard. “It is all about flexibility. You can have them at the low end of the risk spectrum, or at the high end, and everywhere in between. They are a tool rather than an asset class”

However, these products tend to be more complex than equities or bonds, which means educating investors is important. What can be complex for clients to understand is the period between inception and maturity, he explains. “How does the product evolve? It is important that clients understand what might happen during its life.” 

Regular discussions explaining to clients what is going on are therefore important, he says, where the firm can explain whether it still has the same conviction in the underlying, and give a buy, hold or sell weighting to the products. 

FLEXIBILITY

Structured products have changed a lot over the last few years, says Josselin Lecuyer, head of structuring-protection at Theam, BNP Paribas Investment Partners, mainly due to regulation and low interest rates.

 “We are more fond of products with greater flexibility and more active management, than those with locked formula which cannot react to changing environments,” he says. Active managers are able to benefit from the outperformance of the underlyings to deliver outperformance, he argues, which is key when interest rates are so low, although it does come with downside risk.

Italy is a major market for BNP Paribas, and structured products have fared very differently there than in the bank’s French homeland, explains Mr Lecuyer. “Italian govvies didn’t decrease at the same speed as French ones, and until last year you had enough room to launch structured products with good protection and good potential gain, so the decrease in the use of structured products was not as great.” 

In France, the decrease was substantial because investors were used to 100 per cent capital protected products and the switch to lower levels of protection was not easy to put in place because it meant finding a new target market. “You don’t propose a 90 per cent protected product in France to the same target market as full protection,” he says. “So we focused on wealth management clients who could put capital at risk and would be interested in potential uplift.”

Julius Baer on the other hand is focused solely on the Swiss market. “Regulation has had less of an effect in Switzerland than in other jurisdictions where structured products have almost been prohibited,” says Marco Stauffacher, structured products specialist at the Swiss bank. 

The country has always had the idea of self-regulation, which is a reason why its structured products market is one of the largest in the world. There are still more than SFr180bn (€165bn) of these products in client portfolios, which is down from SFr350bn in 2007 but remains an important part of portfolios, he explains.

Things have not changed a huge amount in Switzerland in terms of popular products, says Mr Stauffacher. “Yield enhancement products, barrier reverse convertibles, coupon bearing instruments… all are still very popular. Capital protection is a bit out of favour because of low interest rates – it is very difficult to put something in place and that will not change until we see higher interest rates.” 

However, he is not of the opinion that interest rates have had the biggest impact on the falling volumes of structured products, pointing instead to three other factors. Firstly, following the financial crisis the whole equity market fell dramatically, and most of the time structured products are linked to an equity underlying, which means structured products lost value as well. 

Secondly came the collapse of Lehman Brothers, a big manufacturer of structured products. “Therefore clients lost money. The structured products market in Switzerland reacted to that event by starting to offer collateralised securities, so we now are able to deposit collateral for the products we issue, as we want to avoid another Lehman,” explains Mr Stauffacher. 

“Finally, they fell out of favour as so many people, including the media, seemed to be saying that structured products caused the financial crisis,” he says. “I think they were confusing the products which caused problems, the run on CDOs and CLOs, where people had securitised mortgages, which, by definition, are not liquid. The ones we create are very liquid, because the underlying is very liquid.”

AUTOMATION

The automation of the industry has been another major trend, claims Mr Stauffacher with very little manual work still being done. “To some extent this has been down to the regulatory demands; if you are to have documentation ready before you trade, it has to be automated.” 

Automation has also enabled the market to become more mature, and is making it available to a wider audience. “There are now tools available which enable individual clients with SFr20,000 or SFr 30,000 to tailor their own structured products. Five or 10 years ago that was impossible. They would have to come up with a million minimum and we would structure it.”

Structured products have evolved since the financial crisis and have become much more simplistic. “Before the crisis you saw more complex underlyings being used in products, different types of indices, whereas now everything is very standardised,” says Michelle Bates, UK head of structured products at UBS Wealth Management.

This change has been driven by a combination of client demand and increased regulation. Prips and Mifid II will mean a lot more work being done when putting together products, for example stress testing and making sure the right products end up with the right clients, she explains. “Investment banks have never really had that much responsibility about where a product goes, and now they do as a manufacturer, so we are definitely working a lot closer with each issuer. And that definitely drives down complexity because you can’t be doing that over 25 products. You need to standardise and keep things simple.”

The types of product on offer have also changed, says Ms Bates. Before the crisis capital protection was in fashion, but lower interest rates mean clients are now using them for yield enhancement. If rates were to rise in the future that could mean a return to capital protection. “When rates were at their highest in 2006-7 the structured products you could do were a lot more conservative because you could afford capital protection. So higher interest rates could certainly change the type of products we do, if that is what clients want.”

Most of the products UBS offers are fairly defensive and are not really taking a particular directional view. “The product would pay out if the market stays flat or is slightly negative,” she says. “Clients look at how they complement the rest of their portfolios.” 

For example, if a client has a lot of equity funds which need the market to go up to perform, an equity structured product on the same index or region can provide a payout of 8 or 10 per cent without the market needing to move.  

In terms of asset classes, up to 80 per cent of UBS’ structured products are in equities, says Ms Bates. “We do some fixed income but it is very, very vanilla – we are talking things like floating rate notes, we don’t do anything more elaborate than that. I have heard that other banks are doing credit-linked notes but we don’t do them here for retail clients. We occasionally do commodities but that is very much client specific, if someone particularly wants it.”