First it was Northern Rock, then Lehman Brothers, quickly followed by AIG and then Bradford and Bingley (B&B). It has not been a good few months for structured product providers – their 'usual suspects' list of counterparties used to underwrite final capital payouts for investors has been whittled away with alarming speed.
This counterparty risk, as it's called, really matters with any structured product. The products are usually built in such a way that a big institution guarantees to pay out the final capital sum on a product that either includes an income payout or some growth option that will give private investors anything between 80 per cent and 1,000 per cent of the increase in an underlying index. When an institution goes bust – as Lehman did – that payout effectively vanishes as structured product investors are low down the pecking order in the event of any default.
But counterparty risk is not always black and white – Merrill Lynch (ML), for instance, has a range of structured investment trusts under the Elders brand that features B&B. When B&B first stumbled, Elders fund prices fell, but buyers have started returning as B&B has now been nationalised. Rumours abound that an awful lot of wealth advisers have been snapping up Elders series 24B and 17B shares convinced that the government will pay up.
Another big risk to look out for are those fast collapsing 'barriers', which are supposed to protect the investor – in vicious bear markets, these in fact turn into precipice bonds, crushing capital values. Most sensible barriers are structured so that you get your initial capital back as long as the underlying index or basket of shares doesn’t fall by more than 50 per cent. But, with some shares collapsing by more than 25 per cent in one day, that protection is under threat, especially if the strike level (when the fund or product was set up) was set during the bull market.
Already there have been some small blow-ups: Blue Sky released a structured product that offered geared upside on a basket of banking shares that included HBOS, whose share price crashed below the 'protection' barrier. Investors need to scrutinise their funds if the markets crash back another 20 per cent or so, pushing an index like the FTSE 100 below 4000 – many barrier points for mainstream products have been set at between 3000 and 4000. Investors also need to see whether the barrier is 'observed' using intra-day prices (which can vary hugely and is not advised) or closing prices (the norm for good providers).
But it's not all doom and gloom for structured products. Some companies, including SocGen, have a range of products that make money even in bear markets. Its Bear Certificates, for example, amplify returns if key developed markets fall. And structured products could make an awful lot of sense if markets start to stabilise or even rise. For sideways-moving markets, defensible autocallables could make a lot of sense and pay out very decent returns. In particular M029, a London-listed vehicle from ML costs 89p a share, but could pay out as much as 122p a share if the FTSE 100 is above 4700 in January 2010.
If you're a bull, it might be worth looking at Blue Sky's Asset allocation fund, which pays out 10 times the return on any increase in the main developed world stock markets up to a 60 per cent gain and then offers participation rates of between 125 per cent and 200 per cent beyond that. And SocGen is readying a bull certificate that will amplify returns if markets do start to rise.
