Over the last few weeks a slew of new structured products have been launched targeting perhaps the most 'hard done-by' part of the investment universe – investors looking for an income. This small renaissance is being driven by a number of factors not least a demand from many private investors for a regular, reliable income – one of the biggest traditional sources of investment income, the banks, have all but abandoned the humble dividend as has a great wave of other FTSE 350 companies, desperate to preserve cash.
Many professional advisers are now shouting from the rooftops about corporate bonds – yields are up, especially below investment grade, and some experts think that the central banks may even start buying them up in order to kick-start the broken credit markets. But corporate debt is no free lunch – the risk is that the economic downturn will prompt an escalation in defaults destroying investors capital.
Structured product providers have stepped into the breach with a range of platforms and structures that try to give a reliable income, within a controlled risk profile. The most popular idea at the moment is a steady 6 to 8.25 per cent coupon paid monthly, quarterly or semi-annually based on a 'barrier' – this barrier is one of the key risks and if it's breached the initial capital investment will be jeopardised although you may well still carry on getting the income coupon.
To understand how this might work, it's worth looking at one of the better offerings from covered warrant and listed structured product provider SocGen - its FTSE Protection 2000 certificates. These pay a quarterly coupon - £20 per £1,000 certificate – for the next three years as long as the underlying index (the FTSE 100) doesn't breach the 2000 level. If it does breach this barrier index level, you'll lose 1 per cent of the initial investment for each 1 per cent fall from the initial or opening level when the certificate was issued ie as the certificate was issued when the FTSE 100 was at 4000, if it hits 2000 you only receive back £500 for every £1,000 certificate.
Sounds like a good bet for an investor seeking an income doesn't it ? The truth is that it all depends on your view of the myriad risks involved. The first and most obvious is that FTSE 100 may well actually fall by 50 per cent from 4000 to 2000 – there are a great many analysts such as Albert Edwards (an analyst at SocGen) who maintain that we're in the middle of a new great Depression and that every bull market rally will be followed by another grinding bear market reversal.
And it's this very real fear of real financial meltdown that's driven this rash of new income based products – many big institutional investors are lining up to buy deep out of the money puts (options that make money on falling prices) on big indices like the FTSE 100. They're willing to pay a hefty premium to buy options contracts that effectively make them money if the markets collapse (insurance giant Aviva has been a prolific buyer of these options) in value and structured products providers are only too happy to sell away options that trigger large payouts if structured product barriers are breached.
Against this, it has to be said that even the deep perma-bears like Albert Edwards reckon that a fall to around 2700 for the FTSE 100 is probably the very worst outcome and there are very, very few bears who think we're truly heading to a financial meltdown that would drag share prices back to levels not seen since the 1980s. But the point here is that it could happen and many, many barriers for once safe looking structured products have been breached in the last year.
The next big risk is what's called counter party risk. With SocGen's product that risk is fairly easy to comprehend - it's SocGen, an investment bank, itself. If SocGen went bust, you probably wouldn't get back your money. That could happen and as we now know many, many banks have hit the wall dragging down their structured product counter parties with them (the collapse of Lehman's was a particularly vicious blow to the sector). But SocGen is regarded as one of the safer banks not least because the French government would clearly intervene to defend its national champion – if you go to Blue Sky's web site at www.bluesky-am.com , and visit their counter party platform page you can see all the risk ratios attached to all the big banks and you'll instantly notice that SocGen's 5 year CDS options (an insurance premium to protect against debt issued by the bank) are priced at relatively low levels. But not all the banks are that safe – many of the US banks like Citi are regarded with deep distrust and even once rock solid institutions such as Barclays are perceived as risky.
Another key consideration with all these income based products is how the barrier is 'observed' – how does a big fall in the underlying index actually qualify as having breached the barrier? This might sound horribly technical but it's a simple idea – is the barrier monitored on an end of day basis or an intra-day basis? If it's observed on an end of day basis, the FTSE has to actually close at below 2000 before the barrier is breached. If it's intra-day, the FTSE 100 could trade below 2000 at say 12 noon but finish the day above 2000 yet the barrier would still have been breached. Talk to the experts and it's clear that end of day observation is good news, while intra-day is potentially bad news in very volatile markets. Luckily the SocGen products are observed end of day.
The last key risk to note is access to the investment over the duration of the plan. The SocGen certificate is unusual in that it's actually a stockmarket traded product – its ticker is SG 79 – and can be bought via a broker in real time, at a cost of course that involves a dealing fee and a 1% bid offer spread. That real time pricing means you can buy this product either new or second hand but it also means that the value of the actual certificate can and will vary on a daily basis. If the markets lurch downwards and volatility goes up, this certificate will trade at below £1,000 although if markets rise you can pretty much be guaranteed that it will never trade at above £1,000. That real time pricing doesn't really matter if you're going to hold the product through to redemption in three years time and the barrier isn't breached but investors need to understand that the day to day pricing will vary. Crucially many of the rival providers – Key Data for instance has an extra Income Plan (26) that's paying 8.04% per annum over five years for instance – offer funds that cannot be traded in real time and are not readily accessible over the term of the investment. With products sold through IFAs, if you cash in early you may lose some of your initial investment.
Other Options
These plain vanilla regular income plans – Barclays Wealth also has a 7.5% Income Bond that competes with the KeyData and SG products – are the easiest structured products to comprehend but they're not the only option. Outfits like BarCap, Meteor and especially Blue Sky offer a rival structure called an autocallable.
This is a slightly different take on the same idea. In these products a coupon is paid out annually as a capital gain IF a certain threshold is crossed, triggering a 'call' on the income coupon. This threshold is usually the level of the FTSE 100 when the fund was launched and you get the coupon if the index is at or above that initial level – if it isn't, you wait for another year to see if the index is at or above that initial level. Like the earlier products , there's also a barrier of some sort – usually around 50%, at which point you lose your capital protection.
Meteor is very active in this space and is currently selling its Prima Growth Pan 14 which offers a 13% annual coupon if the FTSE 100 is at or above the initial level set on the 9 April of 2009. If it is, the plan is called and the investor gets a 13% return as a capital gain ie it's not taxed as income and you can use your CGT allowance to take some profits. If it isn't, the plan trundles on for the next five years waiting for the index to hit the initial level – if it doesn't you'll still get your money back as long as the barrier hasn't been breached.
A slightly more cautious version of the same idea is being offered by Blue Sky. Its Capital Accelerator AutoCall Plan Defensive Series II is a 6 year product which offers an annual 7% coupon on call but with a slightly different twist – it's effectively a defensive autocallable in that the coupon is triggered by an index level BELOW the initial level, in fact 15% below that level. Here's how it could work. If the initial level of the FTSE 100 at launch is say 4000, Blue Sky will pay the 7% coupon if the FTSE is above 3400 in one years time (15% below the initial level). If it is you get the 7% coupon as a capital gain, if it isn't you move on to the next year and see whether the defensive level has been hit. The Blue Sky product has a 50% barrier below which your capital is at risk.
There's one last product worth considering for an income – covered call funds. This is an entirely different structure but it still provides some capital protection alongside a steady, above average income. One of the most successful versions of this comes from French bank BNP Paribas via its structured investment trust range. Its UK High Income investment trust offers a stable (but not fixed) payout of around 8p a share – with the shares trading at 80p, that equates to a yield of 10% pa. This income is derived from two main sources – it holds a fairly concentrated holding of high yielding FTSE 350 shares that pay out a bumper dividend income. The fund managers also sell options on those share holdings to other institutions – they sell away any upside in the share price for a fixed period of time (three to 12 months depending on the shares involved) in return for an options fee. This fee plus the dividend income – you don't have to give away the right to the dividend when writing the call option – generates a nice steady income and also pays for some put or downside options that protect the capital value of the fund over the next few years. This put option on the shareholdings doesn't stop the fund dropping in value but it does provide some downside protection, in effect providing a kind of floor to the share price at redemption. Crucially the call writing activity also means that if the FTSE does start shooting up in value, you won't benefit greatly – the fund managers have sold away much of the upside to the options investors who will reap the rewards in the short to medium term (ie the duration of the option they purchased).
