Natasha de Teran looks at the explosion in demand for capital guaranteed products as pension and insurance fund managers seek to stem losses.

Insurance’s appeal tends to rise exactly in line with the risk or experience of loss. Unsurprising then, that in the aftermath of one of the most volatile periods in recent financial history, investors have increasingly been seeking out forms of insurance. The result has been that derivatives volumes have spiked across the board, as investors have sought to directly hedge their exposures or to buy into pre-packaged forms of insurance.

Capital guaranteed products (CGPs), which have long been available, and offer the more cautious investor a safe but steady investment, have now become one of the most popular types of insured products. Pension and insurance fund managers have turned to them in an effort to stem losses and retail banking networks have sought to distinguish themselves by offering a raft of ever-more sophisticated products to their wary customers.

According to Des Byrne, managing director in the European solutions sales group at Barclays Capital, the products that banks are now able to create are so flexible they can be tailored to exactly capture whatever view an investor might hold. The fact that they are also transparent only adds, he says, to their appeal.

Customer care

Investment bankers have naturally been quick to gird themselves to meet the growing demand, building up structuring groups to develop new and innovative solutions for a hungry customer base. While the business is proving profitable for them, it is also highly competitive and demands a significant amount of investment. According to Shaun Wainstein, head of the exotic and new product trading group at BNP Paribas, the products require a huge amount of after sales support. Customers demand constant revaluations, and often want to increase, decrease or re-adjust their investments, he says.

Christian Kwek, head of equity derivative marketing for Europe also at BNP Paribas, says the business can also be labour intensive. Private banks will very often look to investment banks for bespoke products for small groups of customers or even individual customers.

Rashid Zuberi, co-head of interest rate derivatives structuring at Deutsche Bank, adds: “This market is all about innovation. That does not mean products have to be totally new or complex, but innovation is necessary in order to meet the growing demands. To do well in this market you need to be at the cutting edge.”

Choosing a partner

From the customer side, things are no easier. The plethora of offers on the table is often confusing, but choosing the right bank to structure your deal is all-important. Mr Wainstein says: “It’s important to ensure the bank you are buying such products from is fully committed to the market, has the appropriate experience and expertise, risk management skills and credit rating. You need to know that the bank is fully committed to offering these products, and will be around for the long term.”

The process of selecting a bank is complicated because they fiercely protect their innovations, and few of the structures are divulged publicly.

One bank has, however, been willing to discuss one of its recently developed products. Deutsche Bank’s Target Redemption Note (TARN), an innovative note with a guaranteed return and a maturity that fluctuates depending on underlying interest rates, was first conceived last year. Initially interest was slow, but picked up when South East Asian investors began looking at the dollar-based versions. That brought the product to the attention of European distributors, which have since distributed the euro-denominated version of the product widely to their investors. It is now also finding success in its eastern European and Scandinavian currency-based iterations.

Mr Zuberi explains the product’s success: “The TARN, can be used for any type of investment strategy. It can also be adapted to accommodate any kind of interest rate view – and can be based on any underlying asset class.”

That particular flexibility is becoming increasingly important. Bankers say much of the current development in the CGP market is precisely in the sorts of assets to which these are now linked. While CGPs have traditionally been linked to equity or equity index underlyings, bankers point to a recent move toward these products being based on funds and hedge funds, commodities and credit. Mr Zuberi says that there has also been a lot of interest in cross-asset or hybrid products, which combine equity and interest rate views, inflation, commodities or foreign exchange exposures.

Mr Spieler: interest from retail market

Mr Le Liepvre: demand for more hybrid products

Growth in demand

Bankers contend that one the strongest potential areas for growth is in credit-based products. Although these are not new, recent developments in the credit arena are likely to spur interest. Until now, selecting the portfolio of credits to include in such products has not been easy. Distributors have had to select and agree the portfolio with the structuring bank, even though they might not have been experienced in the credit selection process. This has left them open to both the whims of the investment bank selecting the portfolio and to reputational risk.

Hubert Le Liepvre, deputy head of the structured credit group at Société Générale in London, says the recent arrival of widely followed credit index families such as iBoxx or Trac-x has changed this. He adds: “Indices like these bring something very positive to this market and will help to develop it further. The onus of selecting the portfolio is removed from the distributor, so his only concern is how to package the deal.”

Retail interest

The retail side of the market has, so far, been less active in credit-based CGPs than the institutional side. Christian Spieler, head of credit and rate structuring and distribution for Germany and Austria at JP Morgan, expects the retail side of the market to be more willing now to look at these products. He adds: “Both end investors and distributors will find a higher level of comfort in investing in a product linked to a standardised and properly constructed index. As a consequence we expect additional demand for structured credit to come to market.”

Mr Le Liepvre says that a typical credit CGP designed for the retail market has a duration of five years and is based on an index comprised of 50-100 names. The original sum invested would be capital protected, and then, if there had been no defaults within that selection over that period, investors would get a 50% coupon payout at maturity. He adds: “It is a very easy and simple product to understand and market. The risk profile is particularly well suited for retail: offering a regular return with remote risk. The default of a company may happen, but it is very unlikely compared to the bad performance of its equity.”

Later on, and once index-based credit CGPs have become an established retail product, Mr Le Liepvre expects to see demand for more hybrid products with, for instance, a credit and equity correlation, or credit and interest rate correlations.

In the institutional side of the market these have already gained traction. Mr Spieler says there has already been a lot of interest among pension and insurance fund managers in so-called combo notes. He says: “The products these investors typically look for have a AAA or AA-rated principal component, with a coupon linked to an equity, commodity, inflation or rate-based formula which has been tailored to express their views and address their asset liability requirements.”

Pre-packing attraction

This increased focus on asset and liability management is one of the key drivers of the CGP market. Mr Zuberi says that pension and insurance fund managers, who could arguably devise their own, increasingly want pre-packaged derivatives solutions to meet their requirements. But these products, although simple in essence, are necessarily time-consuming to develop. Each one needs to be structured to meet not only the specific duration requirements of each fund manager, but also the regulatory environment in which they operate. In order to do this, banks need to ensure their structuring teams work alongside asset/liability management, regulatory, legal and accounting experts to devise the appropriate solutions. Only by doing so will the current raft of investment banks be able to keep serving the market.

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