Rays of hope

The turbulent conditions that have characterised the past two years have taken their toll on the Australian structured products market. But lessons regarding diversification and capital protection could offer a chink of light to investors. Wietske Blees reports

The past year has been an annus horribilis for the structured products industry. Following Lehman Brothers’ filing for Chapter 11 bankruptcy protection on September 15 last year, stock markets worldwide collapsed and the true extent of the crisis hit home with Australian investors. The benchmark Standard & Poor’s ASX 200 index dropped 35.9% from 4,903.80 on September 12, 2008 to 3,145.50 on March 6, 2009, subsequently rebounding to 4,000.80 by July 17.

As equity markets have plummeted, so too have the fortunes of equity-linked structured products. Those structures with downside barrier options have been hit hard, with many knocking out and paying no further coupon for the remaining life of the investment. Constant proportion portfolio insurance (CPPI) products have also suffered, with many cashing out, leaving investors locked into zero-coupon bonds and unable to participate in any future equity upside. The losses have rattled Australia’s historically conservative investor base, say dealers.

“The mentality that Australian investors could never lose money and would outperform the market has clearly been blown out of the water,” says David Jones-Prichard, executive director of equity derivatives and structured products at JP Morgan in Sydney. “Many investors have come to realise that they never really understood their investments and we are noticing a real move back to basics, both in terms of the underlying for the capital-protected product and the structure of the product itself.”

CPPI travails

CPPI products, in particular, had been popular with Australian investors prior to the crisis. The technique works by dynamically rebalancing portfolios between risk-free assets (for example, government bonds) and risky assets (such as equities), with the aim of ensuring the amount invested in fixed income is sufficient to repay 100% of the investor’s principal at maturity.
When structuring a CPPI product, a floor is set below which the portfolio value is not allowed to fall and the cushion (the portfolio value minus the floor) determines how much money is invested in equities to generate returns. Exposure to the risky assets varies as the portfolio value changes, for instance, if the stock market falls, cash is pulled out of equities and a greater proportion is invested in fixed income to ensure the redemption amount is in line with that promised to the investor. If the portfolio value hits the floor – the minimum level required to provide the guarantee – the investor would effectively be left holding a zero-coupon bond for the remainder of the product’s life.

Bar a few ultra-conservatively structured investments, the equity market freefall at the end of last year has meant most CPPI structures are now locked into cash. One such product is Perpetual Protected Investments Series 1, launched by Sydney-based asset manager Perpetual in June 2007. Initially giving exposure to 14 investment funds, including the Axa Wholesale Global Equity Value fund and the Macquarie International Infrastructure Securities fund, the seven-year product became fully locked into cash and call options, with no exposure to the underlying funds.

As a result, the company has opted to restructure the product, allowing investors to contribute an additional A$0.15 on each dollar invested to regain exposure to the funds. “This investment allows them to regain exposure to the underlying fund and benefit from future market upswings,” explains Russel Chesler, general manager, structured products at Perpetual in Sydney.

In more extreme cases, the asset management company itself has gone bust, leaving investors scrambling to find out how their investments have been affected. This was the case with Edgecliff, New South Wales-based Rubicon Asset Management, which runs a number of funds, including the Rubicon International Leaders Fund – Capital Protected Series 1. Launched in June 2006, the product offered investors leveraged exposure to a portfolio of hedge funds, with 100% capital protection at the 2015 maturity, provided by UBS via a put option. However, with a number of the underlying funds freezing redemptions last year, the company was forced to halt its own redemptions in September 2008. UBS confirmed the suspension of redemptions qualified as an ‘extraordinary event’, causing the put option on the Rubicon International Leaders Fund – Capital Protected Series 1 to lapse. In November last year, receivers were appointed to Rubicon Holdings, the parent company of Rubicon Asset Management.

Tax bombshell

To make matters worse, the ramifications of a tax change announced last year continue to hang over the market for capital-protected equity loans. Capital-protected equity loans allow investors to borrow cash in order to buy stocks or other securities, with the capital protection feature meaning the investor is shielded if the value of the securities falls below the initial loan amount. The investment is structured as a loan, meaning the interest payments are tax deductible – although the capital protection feature is not deemed to be deductible.

In some cases, products are structured with a separate put option, making the non-deductible capital protection cost clearly identifiable. In others, the cost of the capital protection is more obscure, particularly in the case of products where the capital guarantee is provided by CPPI. In these cases, the cost of capital protection is often embedded within the interest rate charge.
Under Australian tax rules, a certain component of the interest rate charge should be attributed to the cost of protection and, therefore, should not be deductible. Prior to last May, the Reserve Bank of Australia’s (RBA) benchmark indicator for personal unsecured loans (currently at 13.5%) was used to determine the capital component of capital-protected borrowings. Following the 2008/2009 budget, however, this was changed to the RBA’s indicator variable rate for standard housing loans (currently 5.75%).

The changes have not been formally passed into law, as discussions are still ongoing, but the new rules mean the interest expense on capital-protected borrowing in excess of 5.75% will now be treated as the cost of capital protection and not deductible if on capital account – reducing the interest rate deduction available to investors.

“While dividends and franking credits will help reduce the after-tax cost, the investor is still left with a substantial capital cost and, therefore, breakeven point for the investment,” says Suzanne Salter, head of structured investments at the Commonwealth Bank of Australia in Sydney.

Combined with the fallout from the financial crisis, the effect on leveraged structured products has been disastrous. “For the time being, leverage is in a state of paralysis. High levels of volatility have substantially increased the costs of leverage, while the uncertainty surrounding the taxation of loans has reduced demand for structures that involve gearing. I’d say structured product volumes are at their lowest point in many years,” says Mark Small, executive director of structured equity investments at UBS in Sydney. This is backed up by anecdotal evidence collected by Perpetual’s Chesler, who reckons the capital-protected loan market has shrunk from A$2 billion at its peak in June 2007 to around A$400 million today.

Nonetheless, dealers say there are reasons for optimism. Most palpably, the collapse in equity markets and the losses racked up by investors across the globe have accentuated the benefits of capital protection. “If anything, the past 12 months have reaffirmed the importance of protection and diversification – two concepts that almost go hand in hand,” says Allen McCristal, head of distribution at Barclays Capital in Sydney. “Structured products can assist investors by providing that diversification to different asset classes, while also including capital-protection features.”

Before the financial crisis, investors typically looked upon capital protection as the price to pay for obtaining 100% leverage. Today, a new group of investors has emerged that wants capital protection as a safeguard against losses. “There is no doubt we are seeing less of the aggressive investors who would only consider capital protection as a means to obtain 100% gearing. There is now a new group of investors interested in capital protection for the sake of capital protection itself. These are typically more conservative investors close to retirement age or those who recognise there is good value over the long term and want to protect their downside risk in the process,” says Jones-Prichard.

However, many investors are wary of jumping back into the same products that performed poorly during the crisis. CPPI is a case in point. While these products allow investors to participate in any equity market recovery while providing downside protection, the fact so many investors got burned and were left holding cash-locked structures has persuaded banks to offer alternatives.

“We have seen less interest in the traditional CPPI structures. Most products carry some enhanced features including, at the very least, some minimal allocation to the underlying asset,” explains Shane Miller, head of structuring in the structured solutions group at Citi in Sydney.

One innovation to emerge is the so-called open-ended capital- protected product. These structures have no minimum investment term and offer limited capital protection – typically a percentage of the value of the portfolio. Whereas an investor in a typical CPPI product would be locked into a zero-coupon bond once the value of the underlying asset falls below the bond floor, the combination of the open-ended structure and lower capital guarantee means investors are able to maintain some level of participation to the risky assets.

“While CPPI uses a zero-coupon bond that locks investors 100% into the bond until maturity if the product value reaches the bond floor, in an open-ended structure that bond floor is absent. If the market turns significantly south, you may sit in cash, which accrues interest. But the cash accrual will progressively get reinvested in the markets, hence benefiting from any recovery,” explains Barclays Capital’s McCristal.

A variety of open-ended capital-protected products have emerged in recent months. In May, for example, Melbourne-based Linear Asset Managements launched its Linear Continuously Protected SMA. The open-ended product offers a limited capital guarantee, equal to 80% of the highest value of the portfolio, and investors can choose between one of three model equity portfolios. The capital guarantee is achieved through a combination of dynamic rebalancing and a swap contract, with the swap provided by JP Morgan.

Meanwhile, ING launched two protected funds in June: the ING Protected Growth Fund 2 and the ING Protected AUS50 Fund. The former provides exposure to the ING Managed Growth fund and offers capital protection equal to 85% of the fund’s highest unit price, backed by a guarantee from ING Bank. The ING Protected AUS50 fund dynamically allocates exposure between Australian shares and cash. However, the dynamic allocation process is based on both market direction and volatility. When markets are rising and volatility is low, the funds exposure to shares increases and vice versa. The product offers capital protection equal to 80% of the fund’s highest redemption unit price, with the protection backed by Barclays Bank.

“We have learned that realised volatility has historically been a good indicator of near-term performance, which allows for a more effective allocation over time to the active portfolio than focusing purely on market price movements,” explains McCristal. “In actual terms, that means an investor is likely to be invested more in the active portfolio at the right times, getting a better return for a similar level of risk.”

Such protection features, however, come at a cost. While a traditional CPPI structure, such as the one offered by Perpetual, will charge an annual fee of around 70 basis points, some open-ended products charge up to 300bp. That leaves some observers sceptical about the prospects for capital-protected structures.

“There is certainly an opportunity for soft capital-protected products that include an element of protection or risk minimisation to allow investors to preserve their gains. Ultimately, however, it will come down to how much they have to pay for it,” says Small of UBS.

While dealers report increased interest for capital-protected structures, it does not mean investors are completely unwilling to take risk. “There remains a segment of the market that is still showing interest in more exotic structures and riskier asset classes, including equities,” asserts Alon Mizrachi, Sydney-based head of sales for the structured solutions group at Citi.
In particular, there is still appetite for reverse convertibles among some investors, with many betting equity prices will not fall too much further from current levels. In their simplest form, reverse convertibles pay an enhanced coupon so long as the reference stock does not fall below a certain barrier. If it does breach this level, the product would redeem in shares at the barrier strike.

Citi, for instance, says it has structured a number of one- to three-year worst-of knock-in reverse convertibles for high-net-worth clients. With knock-in levels typically in the range of 60%–70% of the stocks’ initial price, the structures offer coupons that can exceed 20% per annum. “With volatility still at lofty levels, there is the potential to generate very high coupons. However, investors have to be comfortable owning the worst-performing stock in the event of a downturn,” says Mizrachi.

Small agrees there is a sector of the community prepared to be aggressive and sell volatility at current levels. “We have certainly had success with products designed around the view that we have seen the bottom, such as the Goals product, where any kick-in levels have been set well below recent price levels,” he says.

UBS’s Goals product is a reverse convertible structure linked to the performance of a small selection (usually three) of Australian stocks. So long as none of the stocks drops below a barrier level (65% of the starting price in recent issues), the investor can receive a fixed coupon of between 15–20% per annum over the investment term. However, should one of the stocks fall below the barrier level, the investor is short a knock-in at-the-money put on the worst-performing stock, and will receive the negative performance (if there is any) of the worst-performer at maturity.

Although it has been a difficult year for the industry, there do at last appear to be some indications of a recovery. “The past 12 to 18 months have proven extremely difficult across all asset classes,” says Citi’s Miller. “However, we do think investors have regained some of their confidence in the second quarter of 2009. As a result, the structured products market has also picked up.”