Capital protected

Australia has introduced new rules permitting supers to invest in instalment warrants as well as using gearing for the first time. The move, combined with changes in the country's tax code and a rise in market volatility, is sparking increased demand for capital-protected structured products. By Rachel Alembakis

The dealflow of structured products with capital protection in Australia was estimated at about A$4 billion ($3.8 billion) by industry participants last year, with the market being described as still relatively niche. But a number of factors, including several legislative changes - such as simplifying the tax treatment of capital-protected structured products to clarify full deductibility of costs and interest, and the permission for some superannuation funds to take on leverage - may mean the market is set for stronger growth this year.

Volatile markets are also playing their part. The benchmark Standard and Poor's (S&P) Australian Securities Exchange (ASX) 200 index, for example, has fallen from 6,339.80 points on December 31 to 5,355.70 points by the end of March, representing a decline of 15%. "Partly what's driving the growth of capital-protected structured products is investment banks being able to package protection for investors that are worried about volatility and downside," says Nigel Douglas, head of investment research at Sydney-based consultancy van Eyk. "Equity markets were rallying, property was rallying, but since December 2007, there has been a lot of concern about protecting the downside."

The most common form of capital-protected structured products in the Australian market are zero-coupon bond-plus option, constant proportion portfolio insurance (CPPI) and protected loans. While they have different structures, costs and uses, all guarantee a return of capital at maturity.

The zero-coupon bond-plus option offers investment in a bond sufficient to return 100% of original capital at maturity, with remaining assets used to purchase options with exposure to the underlying investment category.

"What you're doing with a zero coupon plus call is you're locking in a volatility level," says David Jones-Prichard, a vice-president for equity derivatives and structured products at JPMorgan in Sydney. "If you buy a call option, it has an implied level of volatility from now until maturity. Because of recent volatility, a bond plus call is more expensive than it used to be. The exposure an investor receives depends on the underlying asset and how volatile that asset has been."

The CPPI technique uses hedging that varies throughout the product's lifecycle and has the benefit of being cheaper to manufacture than bond-plus structures. But, when a falling market causes the value of the underlying asset to plummet, the manager is forced to unwind positions in the underlying and sell into a zero-coupon bond - this is referred to as being 'cash-locked'. While the manager is not prohibited from buying into the underlying asset again, forced selling and repurchasing hits at the product's return in terms of taxation and costs. The selling of the underlying asset may trigger capital gains tax, for example, and re-buying the asset at a higher price eats into the return.

"Investors compare costs for different gearing packages for protected investments. The message is not to look simply at the headline rate," says Suzanne Salter, head of structured products at Commonwealth Bank of Australia (CBA) in Sydney. "It is necessary to understand the after-tax cost and the opportunity costs that are associated with different structuring techniques. For example, a protected loan may have a headline rate of 15% per annum. However, the after-tax cost - one that takes into account dividends, franking credits and tax-deductions associated with the interest - can be as low as 4% per annum."

She adds that loan packages for CPPI-based products might have a rate of just 9% each year. "However, these products can have an opportunity cost as the exposure to the underlying can deleverage during volatile periods and not necessarily releverage when the performance picks back up," says Salter.

With Australian equity markets seeing heightened volatility in the past six months, some parties say the deleverage risk of CPPI structures has been fully displayed. "CPPI may struggle because of the experience over the last six months," says Mark Small, executive director of equity structured investments at UBS Australia in Sydney. "A lot of funds have deleveraged to levels not previously seen. Some products are close to or cash-locked. It pushes people to the bond and call option structured products."

But other parties believe they have safeguarded investors against this risk. Sydney-based Perpetual, for example, has issued two offerings of capital-protected structured products, the first issued in June 2007, the second in December 2007, with a third scheduled for June 2008, and Russel Chesler, general manager of structured products at Perpetual says it has mitigated against the cash-lock risk by negotiating strongly with its investment bank counterparties on swap option prices and on the trigger points that force unwinding of positions into cash.

"Ultimately, it's a swap agreement with the manager," says Chesler. Perpetual conducted its series I and II transactions with Deutsche Bank, but switched to UBS for series III after securing more preferable terms. "We moved to UBS this time around because we managed to negotiate a better price and a lower trigger; you need about a 20% drop before we go into the cash trigger." Chesler says Perpetual has also mitigated against the trigger event by having a longer, seven-year maturity.

As a result, while series I, launched in July 2007, has seen some selling of assets into cash, neither it nor series II, launched December 2007, have had 100% cash deleveraging, Chesler says.

The third main option available to investors are protected loan structures - usually 100% geared loans against a basket of equities, in which the client is liable for paying the interest on the loan with capital guarantees. Macquarie Bank, for example, in April launched a new protected loan structure - MQ Listed Protected Loan (LPL) - which is quoted on the ASX.

This product features what Macquarie calls a 'unique' walk-away feature in that each year, the purchaser is given the opportunity to walk away from the investment if the product has fallen below levels that the client thinks is worth paying another year's interest.

MQ LPL offers investors the choice of a wide range of ASX-listed shares. For investors looking for international protected exposure, Macquarie's MQ Gateway offers five international themed choices, based on opportunities identified by Macquarie's investment research. "This time around, particularly, the LPL is going to be something quite interesting and exciting for clients," says Pia Cooke, a director at Macquarie's equity markets group in Sydney. "For investors that are familiar with lending, this is giving them the benefits of a protected loan plus the walk-away feature on an annual basis - ability to walk away without paying any additional costs."

Small at UBS believes protected loans will gain in popularity as capital-protected vehicles because they are simple to understand. "This is a big year for them; my personal view is that people are going to go back to basics," he says. "Anything that looks complex, people are going to look away from them. Even though interest rates are going to be quite high on these, the after-tax and break-evens aren't looking too bad on them. It's one of the more successful markets."

JP Morgan as yet does not offer protected loans, and Jones-Prichard is cautious about their effectiveness in a high-interest-rate environment. "We are looking at unlisted protected loans," he says. "As with any type of investment, the economics need to make sense. It's hard for me to say that all protected loans make sense or don't make sense. It depends on your view of the underlying stock. For any product where there's a loan involved, it's becoming harder to make the economics work. Interest rates have gone up, and the higher volatility priced into the protection of the underlying assets means they have become more expensive."

Whatever the structure, the most popular use of structured products in the past five years has been for minimising tax payments. Margin loan providers will permit 100% gearing of capital-protected structured funds of all varieties, not just protected loans - because of their no-loss nature at maturity and due to the interest from the loans used to purchase these products being tax deductable. Even in current market conditions, investment banks are still offering 100% geared margin loans.

As a result, manufacturers typically see a spike in the purchase of capital-protected structured products in the run-up to June 30 each year, the end of the financial year. For example, Perpetual's Series I, issued in June 2007, hit A$160 million in sales, while Series II, issued in December 2007, took in A$56 million. Other distributors tell of similar deal flows.

Encouraging this practice is April 2003 legislative clarification on how the Australian Taxation Office (ATO) views interest deductions. Until 2007, there was significant confusion as to whether it was permissible or not to deduct the interest that is derived from the cost of the options attached to capital-protected products.

The ATO previously said the interest could be deducted if the cost of the options was not separated from the cost of the underlying assets, but could not be deducted if the costs were separated. In November 2002, the federal court ruled in Commissioner of Taxation versus Firth (commonly known as the Firth Case) that the ATO's position was unfounded and the ATO did not challenge this decision. The government amended tax legislation in April 2003 to permit the deduction of interest up to a level designated by the Reserve Bank of Australia - as this article went to press, 14.15%. The result of the legislative change was simpler explanations of products, which has encouraged client buy-in.

"It's a far simpler equation," says Craig Keary, head of sales and distribution for equities at Westpac Institutional Bank. "What it means is that in our calculators it provides a clear picture to the client based on expected dividend yields, based on the interest costs, taking out the protected equity loan, (and what) the after-tax costs will be."

Keary says Westpac includes the after-tax costs on all its term sheets. "That's really important. When a client sees what their costs are, and effectively they have a good, clear number as to how much it's going to cost them on an after-tax treatment, it simplifies matters for customers. That clarification has made it a far easier product to sell."

A second and perhaps more important legislative change is a September 2007 amendment to the Superannuation Industry Supervision Act (the SIS Act) that permitted self-managed superannuation funds (SMSFs) to gear their assets for investment purposes. SMSFs are entities with less than five members and are usually for only one person's retirement savings. Previously, all gearing had been prohibited. With this change, some providers are predicting up to a five-fold increase in their structured products business.

"That's going to have a significant impact. There are many SMSFs whereby the beneficiaries are not that close to retirement and therefore would be quite willing to have a moderate level of gearing in their portfolios," says Cooke of Macquarie. "If you're in the growth phase of life, typically you might entertain having gearing within a super. The fact that it is not a grey area makes it much easier for SMSFs. In the past, limited-recourse loans within supers weren't legislated and it was a grey area."

CBA is currently repackaging its equity derivatives and protected lending products into a new comprehensive 'package' called Options and Lending. This new offering takes advantages of recent changes in tax law and rules surrounding lending to SMSFs.

"Our Capital Series does feature a 100% investment loan for individuals and we're working on one for SMSFs at the moment," Salter says. "We are expecting a big uptick on SMSFs as a result of the legislative changes."

The SIS Act also permitted SMSFs to buy instalment warrants - a derivative financial instrument in which the holder acquires ownership of a share via the payment of two or more instalments. Some investment banks are looking to take advantage of this amendment in the structuring of new products.

"There's a lot of money sitting on the sidelines. Markets have dropped a lot and there are much better opportunities to be seen in stocks at the moment," says Jones-Prichard of JP Morgan. "One of the big things recently is that warrants have been made available for SMSFs. That's probably the most significant event this year and has really determined how we've structured some of our products. Four of our recent products are structured as warrants with internal gearing for SMSFs."

JP Morgan typically develops 10 to 12 capital-protected structured products per year for the Australian market, Jones-Prichard adds.

Westpac is also developing instalment warrant-based products for SMSFs, says Keary. "If you're looking at a self-funding instalment warrant with the ability to gear over a long amount of time and have the benefits of funding your interest, given the market is at a lower level, we're seeing a lot more interest in that, particularly from SMSFs," Keary says. "We're looking at strategies that gear into a range of blue-chip funds over a 10-year period. It's a sensible strategy with a tradable entity."

Manufacturers and distributors are also looking to new underlying assets for structured products, including hedge funds and foreign exchange. "What clients are finding now is that you need a balanced approach in what you can achieve with a fund of hedge fund structure, but where you're trying to achieve a low volatility, above benchmark return," says Joerg Koeppenkastrop, director of products, Next Financial in Sydney.

"In general, the public views hedge funds as a high-risk, high-return strategy," says Koeppenkastrop. "Taking the volatility out of that takes high income out as well. You are left with an income-type return with the possibility to outperform. In my view, the demand for that will increase. It has been a growing industry over the past few years with the potential for further significant growth in demand for quality managers."

Small at UBS says the Swiss bank is also looking at capital-protected structured products with foreign exchange underlying assets. "We are looking at foreign exchange underlyings," he says. "People will want to diversify more going forward, so it's a logical thing. My concern is complexity. I'm not sure that the market will be ready for anything too complex in terms of hybrids. It is important that retail investors are able to clearly understand the exposure they are taking on through these products."

However, at least until the end of the tax year, the focus will be on distributing tax-efficient vehicles.