Low volatility and low yields are making life tricky for structured product providers. But by broadening their range of products and by doing more to tap upcoming markets, such as Asia, they have been able to ensure they get plenty of business. 

For structured product providers, the continuous tightening of credit default spreads for both corporate entities and financial institutions over the past 12 months has been a challenge.

In the years following the financial crisis, and into the first half of 2013, product providers had been able to deliver capital protection and attractive coupons using their own funding levels, in combination with an equity pay-off. At the same time, credit-linked notes (CLNs), that combined the credit risk of the issuer with a corporate name to generate a generous coupon, were highly favoured by investors. For example, at various points during the eurozone crisis in 2012, credit default swaps (CDS) for blue-chip Spanish companies were trading very wide. Private wealth management clients were more than happy to have credit exposure to companies that they personally felt very comfortable with.

Altered landscapes

But the environment has since changed, in particular since the sense of crisis surrounding the euro has receded. Since mid-2013, corporate CDS spreads have tightened across the board, and bank issuers have seen their own funding costs reduce dramatically. Furthermore, banks currently have high levels of liquidity and do not wish to raise additional funding via their structured products issuance.

In this challenging environment, distributors have had to give up what one banker calls the ‘sacred cow’ of full capital protection. The distributors had been reluctant to do this, since they have understandably become wary that they are liable for the advice they give clients, either mass retail or private wealth management, in a much more regulated environment.

But, with yields and volatility low, they have been forced to broaden their structured product range to put some capital at risk, which requires a high level of explanation to investors.

As a result of these changes, the landscape for structured product providers has changed considerably. The biggest loser in terms of issuance volumes has been simple CLNs on a single underlying.

Autocallable winners

The biggest product category winners have been autocallable structures, which might typically have a five-year life and either pay out a fixed coupon every 12 months or extend for another year if the barrier, often set at 60% of the original share value, has been hit. If the shares are below the barrier price at the end of five years, the investor gets a quantity of shares in the underlying that reflects the partial loss of capital.

“In spite of European equity markets looking more bullish than they have for several years, a significant switch from yield enhancement to long-only equity pay-offs is yet to happen,” says Alain Alev, head of equity derivatives sales at HSBC. “Instead, clients are continuing with yield enhancement products and have generally accepted that in the low-volatility environment yields are going to be lower.

“Capital guaranteed products have largely been phased out and the new bestsellers in 2014 are autocallable structures, typically with a 60% or 70% barrier.”

Mr Alev says the appetite for particular products depends on the type of investor in question. “For retail investors, an appetite for complexity has broadly not returned, and distributors favour simple pay-offs because of more stringent regulations. For more sophisticated private banking clients we are seeing more autocallable structures, with three or four stock or index underlyings, rather than products with single stock underlyings. And, we do see some requests to combine an equity pay-off with a credit play, such as an emerging markets bond, in order to enhance yield, but this remains a niche product.”

Domestic focus

What unites retail and private wealth management clients is that both have a clear domestic focus. After the financial crisis, most investors began to show a preference for the stocks and credit names that they felt most comfortable with. This emphasis on domestic underlyings still characterises the market, with the Euro Stoxx 50 one of the few underlyings favoured across national borders.

"For the past two years, distributors have become more comfortable selling non-capital-guaranteed equity pay-offs to retail clients," says Jean-François Mastrangelo, head of engineering in Société Générale’s cross-asset solutions team. "Since last year, retail investors have typically started investing in simple structures without capital protection, and volumes have exceeded our expectations. As long as rates stay low, we believe this switch away from capital protection will remain. This shift towards increased diversification in the capital at risk is also due to the decline of implied volatility, which makes standard indexations on Euro Stoxx 50 less and less attractive.

"This worsening explains the emergence of two sources of outperformance on the private banking side, and that is either going hybrid or taking a more granular approach to stock underlyings.

"Some private banking clients choose a corporate credit, which they know well and feel comfortable with, and mix asset classes by combining a CDS with an equity pay-off on a stock index or on a basket of stocks, for instance. Current sentiment on equity markets has also triggered a renewed interest in stock picking, which comes at the right time given the deterioration of standard Euro Stoxx 50 structures. Another feature of the market, common to both retail and private banking clients, is the lengthening of product maturities. Investors know that they have to go further out in order to increase performance, or at least maintain it compared with previous years' standards." 

Keeping it simple

This mixing of credit and stock pay-offs is regarded as too complex for retail investors by European regulators, and is targeted at private wealth management clients. But, in countries with more conservative investors focused mainly on wealth protection, even private banking clients remain wary of adding levels of complexity to the products that they buy. This has been the case in Germany since the financial crisis.

“Our policy is to keep it simple, especially since the distributor needs to be able to clearly explain the structure to the client, so we don't, for example, mix credit with equity pay-offs by adding exposure to a reference credit in addition to the product issuer,” says Dominik Auricht, a product expert at German lender HypoVereinsbank. “In today’s market, the less complex a product is, the better it will sell.”

However, given the difficulty in generating yield, clients have accepted that they need to take on more risk, and there has been a move away from capital-protected products. Distributors need to find products for their clients, and so have been willing to give up on capital protection and recommend products with added risk.

“The biggest change in the German market during 2014 is that there has been a big comeback for autocallable structures,” says Mr Auricht. “For example, we are seeing strong demand for our express plus certificates with single stock underlyings such as Daimler or BMW.”

In Asia, product providers are also facing the challenge of generating yield in a low-volatility environment, especially given that they serve an investor base less willing to accept falling yields than is the case in Europe. 

Asia thrives

Nonetheless, structured product providers are generating big volumes across Asia. For example, the wealth and investment management division of Barclays has seen tremendous growth in its Asian structured products business, with volumes tripling since 2010. Asia now accounts for 50% of structured product sales in the private bank globally.

“Volatility across major markets has decreased significantly and, recently, the volatility index, which is often referred to as Wall Street's 'fear gauge', fell to its lowest level since before the financial crisis,” says Irene Chen, head of structured products for Asia-Pacific, the Middle East and Africa at Barclays. “This low volatility environment is making it more difficult to generate yield through structured products.

“But Asian wealth management clients, who are typically focused more on wealth accumulation and less on wealth preservation than might be the case in the European structured products market, nonetheless remain quite aggressive in terms of their target yield.

“Many of these high-net-worth clients have switched from single stock underlyings to worst-of structures with two or three stocks in order to generate a higher coupon contributed by the underlying correlation.”

Popular underlyings include Hong Kong-listed stocks giving access to Chinese sectors such as retail, technology or property, and blue-chips from Japan, the US and Europe.

Compared to stocks, indices are less common as underlyings, since wealthy Asian clients prefer physical settlement in shares if the worst-of barrier is breached. This gives them the flexibility to sell the shares, which are typically blue-chips with strong fundamentals, at their own time of choosing upon taking physical delivery of the underlying shares, and waiting for a market rebound.

In the Middle East, Barclays has also enjoyed a lot of success with fixed-coupon products with commodity underlyings. These commodity-linked notes tend to be quite short dated, with favoured underlyings being crude oil or precious metals. As is the case with Asian flow products, the emphasis is on simple structures and pay-offs.

Credit rises

Equity pay-offs remain the favoured structure even for investors looking for a coupon, but credit products have also broadened their appeal across the market, even though the underlyings have become more complex. Many investors began to sit up and take notice of credit opportunities when the CDS spreads of major European companies and financial institutions were trading very wide in 2012. Those days are gone, but investors have grown used to credit as part of their portfolios and are thus open to new credit stories and underlyings.

“Over the past 12 months we have seen a strong development of credit structures for both retail and private wealth management clients," says Benoit Petit, European head of sales at at Société Générale's cross-asset solutions team. "Two or three years ago, CLNs were more of a product for private banks and independent asset managers, who were tracking single names, baskets or perhaps first to default for the more sophisticated clients. But distributors to retail networks are now becoming much more aware of credit as they try to find some yield for their clients.”

However, two or three years ago CDS spreads were still at high levels, so creating yield opportunities was relatively simple, even for single names. Today, it is much more challenging, and private wealth management clients have moved on to the next step, looking at different tranches of risk on underlyings such as the iTraxx indices.

Earlier this year, Société Générale launched a '6 to 20' CLN, which is exposed to reference entities in the iTraxx Crossover Index Series 20. This is a basket of 50 European high-yield names, including British Airways, Cable & Wireless, Fiat, Lafarge, Nokia, Renault and TUI.    

Société Générale’s product is a five-year US dollar-denominated CLN. Investors get a 6.05% annual coupon and full repayment of capital at maturity provided that less than six reference entities are impacted by a credit event. Thus there is no capital guarantee, but the entire capital would only be wiped out if more than 20 names defaulted.

For more conservative investors there is a '21 to 50' CLN. This uses the same basic structure, but pays a lower 3.55% coupon. In this case there is full repayment as long as less than 21 reference entities experience a credit event. This is a so-called super senior tranche, with the 6 to 20 being a mezzanine product.

Flexibility wanted

Being able to choose a level of spread versus protection makes such products flexible for investors. Tranched credit risk on underlyings such as iTraxx has become popular with private wealth management clients right across Europe, in markets as different as Italy, Spain, Switzerland and the Nordic countries.

Counterparty risk remains an important concern for many investors and, in the UK, Société Générale has helped address this by offering products that spread investment risk equally over four well-known financial institutions – Barclays, Lloyds Banking Group, Royal Bank of Scotland and Aviva – while at the same time mitigating Société Générale counterparty risk through the use of collateral. Such collateral is composed of gilts, investment-grade bonds or FTSE stocks held by independent custodian Bank of New York Mellon and monitored daily.

If Société Générale’s issuer were to default or become insolvent, the product would terminate early. However, unlike traditional investments, investors would benefit from the collateralisation mechanism. Collateral assets would be sold with the aim of recovering the current value of the product.

“Counterparty risk remains a key concern for UK investors and regulators alike, so in August 2013 we launched the 'UK four' range of products, which have a standard autocallable equity underlying pay-off but where investment risk is spread across four well-known UK names," says Didier Imbert, head of sales for the UK and Ireland at Société Générale’s cross-asset solutions team.

“We have generated significant volume with these products in the UK retail space, and for private wealth clients we are now taking the next step by allowing them to choose their own underlying credit risk exposure, which can enhance yield. For example, a recent bespoke trade offered investors a basket of three or four major supermarket chains as the credit exposure."

The low-volatility environment is a challenge for structured products providers, particularly because excessive complexity is no longer favoured by either distributors or end clients. The industry focus is more on finding the right equity pay-off or credit story than innovation.

However, the positive news is that investors are willing to take on a bit more risk in their structured products holdings. And they are once again willing to listen to research-driven equities growth stories, instead of only taking defensive non-decrease products on major indices such as the FTSE 100 or the DAX.

Having research-driven themes has become important again. These single stock or sectoral themes can be cross-filtered, with the product provider's own research added to the in-house viewpoint at private bank distributors.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter