Why does the participation rate used in structured products change?

Since 2022 interest rates have been rising around the world and providers of capital protected structured products have been able to offer investors attractive participation rates. However, in recent months as inflation has started to decrease and market expectations of lower interest rates in the future increase, we have seen the participation rates offered by capital protected structured products starting to vary significantly. This has led many to question how the participation rate is determined and what causes it to go up or down. In this article, we aim to explain the most common reasons for the participation rate to change.

What is a participation rate and how is it determined?

The participation rate in structured products refers to the percentage of the underlying asset’s performance that the investment will track.

The participation rate is determined by the Issuer of the structured product, usually a bank or financial institution, and is based on several factors, including the desired risk-return profile, the cost of the underlying assets or derivatives used to create the structured product.

The protected note can be decomposed into two key parts 1) a zero-coupon bond that provides the capital protection at maturity and 2) a participation in the growth of the underlying usually obtained by a call option.

The level of participation rate can be influenced by a range of factors including the level of prevailing interest rates, the creditworthiness of the Issuer, the volatility of the underlying assets, and the length of the investment term.

Interest rates

One of the main determining factors driving the protected note terms are interest rates. If interest rates move down, the Issuer must spend more on the capital protection as the zero-coupon bond becomes more expensive and have less money available to buy the participation in the growth of the underlying asset such as a fund or an index. Consequently, this means protected notes will have lower participation rates and the existing notes will become more expensive when interest rates drop (therefore an inverse relationship exists between the two).

Creditworthiness of the Issuer

The creditworthiness of the Issuer of structured products can also impact the participation rate levels. If the Issuer has a strong credit rating the zero-coupon bonds will be more expensive and again less will be available to buy participation in the growth of the underlying asset.

Volatility

Participation is usually obtained by a call option. The call options become more expensive when market volatility increases due to heightened uncertainty of future performance. Underlying assets with higher volatility can move further from their current levels, meaning the positive returns can be greater if the underlying asset’s volatility is high, while in the case of call options and 100% capital protected notes, the losses are limited to zero.

Investment term

In most cases, the longer the investment term the lower the cost of zero-coupon bonds and the higher the cost of call options. Although this relationship is not strictly linear, and the cost of call options tends to increase by less than what can be saved on the zero-coupon bond. This said it can still allow the Issuer to offer a higher participation rate because in relative terms, further away to maturity, the cost of the zero-coupon bonds decreases more compared to the increased cost of the call option, and the Issuer may be able to purchase more participation in the growth of the underlying asset.

What does this all mean in practise?

In the last few months, longer term interest rates have started coming down and together with lower funding rates from banks, this has been pushing participations lower in more recent protected notes.

Source: Bloomberg as at 12 December 2023.

The below graphs show the value of two parts, the zero-coupon bond, and the participation, at inception and at maturity assuming two different market scenarios: one with positive 40% growth and one with negative growth.

The blue part is the zero-coupon bond that is mainly affected by the interest rates and the Issuers creditworthiness. The golden part is the amount available to buy the participation in the growth of the underlying asset.  If interest rates drop and the credit risk of the Issuer reduces the cost of the zero-coupon bond will increase and less will be available for the participation and vice versa.

  

Source: Causeway Securities as at 12 December 2023. This graph is for illustrative purposes only.

At maturity, the zero-coupon bond will grow to the level of capital protection offered by the note (for example, 95% of the invested capital) and if there is any growth of the underlying assets this will be added on top. For example, if the note offers 120% participation and the growth of the asset was 40% over the term, the note will redeem at maturity 148%. And if the growth of the asset was negative over the term, the note will redeem at maturity 0% and the investor would only receive their capital back (subject to the Issuer credit risk and as long as the performance was within the capital protection level).

Conclusion

The level of participation is specified in the structured note’s terms and conditions at the time of issuance. This can vary significantly depending on factors, such as the level of prevailing interest rates, the creditworthiness of the Issuer, the volatility of the underlying assets, and the length of the investment term.

Investors should carefully consider the level of participation on offer and other terms that affect both the potential return and the level of risk associated with the investment before making an investment in a structured product.

If you want to know more about participation levels and Capital Protected Products offered by Causeway Securities, please contact us.

Important information

This publication is intended to be Causeway Securities Limited’s own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade-in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling-denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

As with all forms of investment, there are risks involved with structured products, including those on our website.

It should always be understood that:

– Structured products are not suitable for everyone

– Past performance is not a reliable indicator of or guide to future performance and should not be relied upon, particularly in isolation

– The value of investments and the income from them can go down as well as up

– The value of structured products may be affected by the price of their underlying investments

– The potential returns of a structured and the repayment of money invested in a structured product depend on the financial stability of the Issuer and Counterparty

– Capital at risk and investors could lose some or all their capital

Causeway Securities Limited is authorized and regulated by the Financial Conduct Authority (FCA FRN 749440) in the UK and in South Africa Causeway Securities Limited is an authorised financial services provider in terms of the Financial Advisory and Intermediary Services Act (Act No. 37 of 2002). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

What is a range accrual note?

One of the key considerations for investors is whether they anticipate an asset to increase or decrease in value. There are three ways the investor can approach this:

The investor can anticipate an increase in the value of an asset and look to benefit from a rise. This is known as a long position.

The investor can anticipate a decrease in the value of an asset and look to benefit from a fall. This is known as a short position.

The investor can anticipate that the value of an asset may remain volatile but move sideways over the short to medium term. This is known as a range-bound position.

Executing a range-bound position can be complex for the end investor; however, ‘range accrual’ type of structured notes can provide investors with ease of access to this type of investment.

The returns paid by a Range Accrual Note are determined by observing the price of an underlying asset (an ‘Underlying’) on multiple observation dates over a given period. Depending on the product chosen, the return can either be accumulated and paid at Maturity or distributed as income over time.

How do range accrual notes work?

Let’s look at a few hypothetical examples.

Accumulation Range Accrual Note, with weekly observations

Key parameters are set below:

Underlying: FTSE 100 Index
Term: 6 years
Accrual Rate: 70%
Accrual observation frequency: Weekly
Capital Protection Barrier: 70% (European barrier)
Accrual Range: Index level of 5500 to 8500 points
Credit Exposure: An A-rated issuer
Product terms are entirely hypothetical and are used as an example and may vary depending upon prevailing market conditions.

The Note pays an accrued return linked to the performance of the FTSE 100 Index (the Underlying). The Accrual Rate of 70% is used to determine the final return paid by the Note at the end of its term. This accrual rate (70%) is multiplied by the total number of the weeks that the FTSE 100 is observed within the stated accrual range divided by the total number of weeks in the investment period. The range is set between 5500 and 8500 points.

Return = (Accrual rate) x (Number of weeks within the range / Total number of weeks)

For example, if the Underlying stays in the range the whole time, the note pays 70% return at Maturity. If the Underlying is in the range only half of the weeks, the return will be 35%.

Capital redemption in our example is also linked to the Underlying. If the FTSE 100 is down by less than 30% from the initial start level (the strike level), the investor receives their capital in full, along with any return accrued. However, if the FTSE 100 is down by more than 30%, the investor will see their capital reduced by on 1 to 1 basis along with the underlying from the initial level.

Source: Bloomberg, 27 January 2023

 

An Income Range Accrual Note, with annual Observation Dates.

Key parameters are set below:

Underlying: FTSE 100 Index
Term: 6 years
Income Range: 10% p.a.
Accrual observation frequency: Annual
Capital Protection Barrier: 70% (European barrier)
Accrual Range: Index level of 5500 to 8500 points
Credit Exposure: An A-rated issuer
Product terms are entirely hypothetical and are used as an example and may vary depending upon prevailing market conditions.

 

The Note pays an income linked to the performance of the FTSE 100 Index (the Underlying). The Income Rate of 10% is paid on each annual Observation Date if the value of the Underlying on the relevant Observation Date is within the Accrual Range of 80% – 120% of the Initial Value of the Underlying. For example, if the Initial Value was 5000, the investor would be paid the return if the value of the Underlying on the Observation Date is between 4000 and 6000 points.

Capital redemption in our example is also linked to the Underlying. If the FTSE 100 is down by less than 30% from the initial start level (the strike level), the investor receives their capital in full, along with any return accrued. However, if the FTSE 100 is down by more than 30%, the investor will see their capital reduced by on 1 to 1 basis along with the underlying from the initial level.

Conclusion

Range accruals are an excellent way to create an investment position for the investor who believes the market will be moving sideways over the investment horizon. In the volatile and high-rate environment, these products offer an excellent value proposition as we are able to achieve relatively wider ranges with high potential returns.

If you want to know more about Range Accrual Notes and how Causeway Securities could help you, please contact us.

 

Important information

This publication is intended to be Causeway Securities Limited’s own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade-in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling-denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

As with all forms of investment, there are risks involved with structured products, including those on our website.

It should always be understood that:

– Structured products are not suitable for everyone

– Past performance is not a reliable indicator of or guide to future performance and should not be relied upon, particularly in isolation

– The value of investments and the income from them can go down as well as up

– The value of structured products may be affected by the price of their underlying investments

– The potential returns of a structured and the repayment of money invested in a structured product depend on the financial stability of the Issuer and Counterparty

– Capital at risk and investors could lose some or all their capital

Causeway Securities Limited is authorized and regulated by the Financial Conduct Authority (FCA FRN 749440) in the UK and in South Africa Causeway Securities Limited is an authorised financial services provider in terms of the Financial Advisory and Intermediary Services Act (Act No. 37 of 2002). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

 

Unlocking the benefits: Why Invest in Capital Protected Structured Note?

Capital Protected Structured Notes have emerged as an option that has captured the attention of both seasoned investors and newcomers. Offering a unique blend of capital protection and potential returns, these products have gained popularity for their ability to balance risk and reward. In this article, we will delve into the reasons why investing in Capital Protected Structured Notes could be a prudent choice for those seeking a well-rounded investment strategy.

What are Capital Protected Structured Notes?

Before we dive into the benefits of investing in Capital Protected Structured Notes, let’s briefly recap what they are. A Capital Protected Structured Note is a financial instrument designed to provide investors with exposure to the growth opportunities of various asset classes, such as stocks or equity market indices while offering a level of downside protection.

These products are typically created by financial institutions and involve a combination of a bond component (providing capital protection) and an option which offers participation in the growth of the Underlying Asset.

Source: Causeway Securities, for illustrative purposes only

What are the benefits of investing in a Capital Protected Note? Why would someone be interested in investing in a Capital Protected Note?

At times of uncertainty or long market rallies, some investors may feel the need to preserve their existing wealth and look for investments that offer a level of capital protection and opportunities for growth.

The key benefit of Capital Protected Structured Notes lies in their ability to safeguard some or all the invested capital at Maturity. This protection acts as a safety net, ensuring that even if the value of the Underlying asset declines, the initial investment remains intact. However, this does not mean that there are no risks at all as the clients are still exposed to the credit risk of the issuing entity.  This means that such products only provide a full return of capital if the issuing entity does not default.   In the event of this happening an Investor could lose some or all of their investment as well as any of the returns to which they may otherwise have been entitled.

The other benefits are:

Diversification: These products can provide exposure to a diverse range of assets allowing investors to spread risk across different sectors, industries, or geographic regions, potentially enhancing the overall stability of their portfolio.

Customisation: Capital Protected Structured Notes can be tailored to meet specific investor needs, such as risk tolerance and investment horizon. This customization can include choosing the Underlying assets, the level of capital protection, and the potential return profile. All this provides investors with a degree of control over their investment strategy.

Access to riskier assets for higher returns: For example, holding equities outright in the portfolio might be too risky for certain investors, but a Capital Protected Note reduces the risk while offering similar growth potential as the Underlying Asset.

Structured Risk-Reward Ratio: Capital Protected Structured Notes are designed with predetermined risk-reward profiles, allowing investors to assess potential outcomes before making an investment decision. This transparency can be especially appealing for those seeking a balanced approach to risk and return.

When would you suggest that an adviser considers this for their clients?

This type of investment is appropriate for investors in the accumulation stage of their financial planning journey who want exposure to market gains without risking their entire investment. These products usually offer participation in the selected Underlying Asset, for example, 100% of the performance of the S&P 500 Index. In other cases, the participation can be increased to, for example, 150% by reducing the return potential. This means that at Maturity if the S&P 500 is up 25% the investor would receive a boosted return of 37.5%.

The participation rate offered by Capital Protected Notes depends on a lot of market parameters with interest rate being one of the most important ones. This is why the participation rate can change from one issue to another.

These notes offer protection but also leveraged returns; sounds too good to be true?

These types of investments allow investors to access the markets with a different risk-return profile than the traditional route via funds.  With this kind of investment, investors can give up some of the very high return potential and the potential dividends in exchange for capital protection and a defined return profile.

How is the Underlying selected?

The Underlying can be a single asset or a basket of assets. Which asset is selected depends on the investment objectives and desired risk profile, but most Capital Protected Notes use equity investments as an Underlying.

Expected long-term returns for equity investments can vary based on a range of factors, including economic conditions, market performance, geopolitical events, and more. Historically, equities have provided higher returns compared to other asset classes over the long term, but these returns can fluctuate significantly over various times and regions. It is important to note that past performance is not necessarily indicative of future results.

While past performance is not a guarantee of future performance the long-term average annual returns for equities in the past were:

Global Equities: Historically, global equities have yielded an average annual return of around 7% to 10% over the long-term considering various market cycles, including periods of high growth and periods of economic downturn.

Regional Equities:

-United States: U.S. equities have provided an average annual return of around 7% to 9% over the long term.

-Europe: European equities have historically yielded an average annual return of approximately 6% to 8% over the long term.

-Asia: Equities in Asian markets, such as Japan and emerging economies, have seen average annual returns of around 8% to 10% over the long term.

-Developed Markets: Equities in other developed markets have typically generated returns similar to the global average, ranging from 7% to 10%.

Source: Bloomberg as at 10 August 2023.

Conclusion

In an investment landscape marked by volatility and uncertainty, Capital Protected Structured Notes offer a compelling solution for those who seek to strike a balance between capital preservation and potential returns. These products provide a unique combination of features, including capital protection, diversification, customization, and access to various asset classes. By understanding the benefits and carefully evaluating their risk-reward profiles, investors can incorporate Capital Protected Structured Notes into their portfolios to achieve a more well-rounded and resilient investment strategy.

As with any investment decision, thorough research, consultation with financial professionals, and alignment with one’s financial goals are essential for making informed choices. For more information on Capital Protected Structured Notes and how Causeway Securities products can help you, contact us.

 

Important information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

As with all forms of investment, there are risks involved with structured products, including those on our website.

It should always be understood that:

-Structured products are not suitable for everyone

-Past performance is not a reliable indicator of or guide to future performance and should not be relied upon, particularly in isolation

-The value of investment and the income from them can go down as well as up

-The value of structured products may be affected by the price of their underlying investments

-The potential returns of a structured and the repayment of money invested in a structured product depend on the financial stability of the Issuer and Counterparty

-Capital at risk and investors could lose some or all their capital

 

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

Importance of Issuer Diversification

Do not put all your eggs into one basket is an age-old saying that rings true when it comes to investing from stocks and shares to investment funds or structured products. Diversification is an important strategy for managing risk in any investment portfolio. In this article, we will discuss why Issuer diversification, a key component of structured products, is important and what are the benefits.

Structured products, due to their ability to provide defined returns, are a great tool to add diversification to any investment portfolio. One of the best ways to enhance diversification within a portfolio of structured products is to spread investments across multiple Issuers. An Issuer is the Issuer of the structured product, usually an investment bank. Issuer diversification will ensure that not all your investments are impacted if one Issuer would fail on their obligations and defaults.

Whilst Issuer defaults are not a common occurrence, the demise of Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank in the US and UBS taking over Credit Suisse (CS) in Europe earlier this year highlight the importance of not over-relying on any one Issuer. Banks are subject to tight regulation and reporting, but we should not forget banks’ sensitivity to market confidence and liquidity.

The key benefits of Issuer diversification

Mitigates credit risk

Issuer diversification can reduce credit risk, which is the risk that an Issuer will default on its financial obligations. If investors have all their investments with one Issuer and that Issuer defaults, they could lose all their investments. However, if investments are spread across multiple Issuers, the risk of losing all investments is greatly reduced.

Reduces concentration risk

Concentration risk is the risk of having too much exposure to one Issuer or investment. This can occur if one invests heavily in one company or hold all their investments with one bank or broker. If that Issuer or investment performs poorly, investors can suffer significant losses. Issuer diversification helps to reduce concentration risk by spreading investments across multiple Issuers.

Enhances portfolio performance

Diversification is a key driver of portfolio performance. By spreading investments across multiple Issuers, investors can capture the benefits of diversification, such as reduced volatility and increased and/or more consistent return over time.

Provides access to different investment opportunities

Different Issuers may offer different investment opportunities via different underlying assets such as stocks, bonds, or mutual funds. This can help to improve portfolio’s risk-return profile and increase chances of achieving investment goals.

Provides flexibility

Issuer diversification provides flexibility to adjust portfolios as investment needs and goals change over time. By spreading investments across multiple Issuers, investors can easily adjust portfolios to take advantage of new investment opportunities or reduce exposure to certain types of investments.

 

Conclusion

In conclusion, Issuer diversification is an important strategy for managing risk and improving portfolio performance. By spreading investments across multiple Issuers, investors can reduce credit risk, and concentration risk, and gain access to different investment opportunities. It can also provide flexibility to adjust portfolios as investment needs and goals change over time. Therefore, it is important to consider Issuer diversification as part of an overall investment strategy.

Causeway Securities is an independent brokerage company and not tied to any one Issuer, we offer structured products from a number of A-listed Issuers. For more information on Issuer diversification and how Causeway Securities products can help you to add diversification to your clients’ portfolios, contact us.

Important information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

As with all forms of investment, there are risks involved with structured products, including those on our website.

It should always be understood that:

-Structured products are not suitable for everyone

-Past performance is not a reliable indicator of or guide to future performance and should not be relied upon, particularly in isolation

-The value of investment and the income from them can go down as well as up

-The value of structured products may be affected by the price of their underlying investments

-The potential returns of a structured and the repayment of money invested in a structured product depend on the financial stability of the Issuer and Issuer

-Capital is at risk and investors could lose some or all their capital

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

 

How structured products can help to meet investors return expectations

Equity investors are known to expect high returns, often double digit, in exchange for the risk they take. But over the past decade, have equity market delivered on these expectations or not?

Looking at the last 10 years, equity returns around the world range between 6% p.a. and 12% p.a.

Source: Bloomberg, March 2023

Over the past 10 years, FTSE 100 generated a total return of 6.1% p.a. of which only above 2% p.a. is price return, and the rest is from dividends reinvested into the index at the spot price.

To generate returns of this level does not necessarily require full equity risk

Structured products can help to generate similar returns with higher probability than the equity market.  For example, GBP 5-year memory income autocall note (Note) with 80% coupon barrier could generate 6.1% p.a. even if the market would be down 20% and any missed coupons would be paid when the conditions are met again. In addition to this if the Note runs to maturity and the index ends above the capital protection barrier, 100% of the capital would be repaid even if the index would be down up to 35%.

Structured notes provide investors flexibility

Structured notes can offer investors flexibility to adjust the parameters and shift the risk-return profile to suit their need.

Including structured products in the investment portfolio may help to optimise overall risk/return ratio of the portfolio as they may offer not only capital protection but also stability and a level of certainty over potential future growth.

An important feature of structured products is that they enable the investors to remain exposed to equity market performance without significantly increasing the risk of their overall portfolio. This may help investors achieve their investment goals which may otherwise be unattainable. In other words, the investment goal may not be achievable with a traditional balanced portfolio while an adventurous all equity portfolio may be too risky for the client’s risk profile.

Example structured notes

Please note these examples are for illustration purposes only and not based on real market events. Structured products are capital at risk products, meaning whilst they may offer full or partial capital protection this is not guaranteed and is subject to the default risk of the issuer.

Product A – A 100% capital protected note that offers investors 130% participation in the performance of an underlying equity index (for example FTSE 100) at the end of a 5-year term.

In five years’ time, the investor would expect to get their capital back and 130% of the upside performance of the FTSE 100, subject to issuer default risk. The growth received will not include any dividend payments as structured products use dividends to increase the participation and to finance the capital protection.

Product B – An income autocall note with 5-year term that offers the investor a predefined return of 7% p.a. linked to performance of an underlying equity index (for example European stock index). The return is payable on the given observation dates if the underlying is at 80% of its initial level or above (this is known as coupon barrier). The product B also has a 65% capital protection barrier; this means investor will get all their capital back unless the market has fallen by more than 35% at maturity. In such situation the initial investment will be reduced on a one-to-one basis.

If in five years’ time, on the last observation date (assuming the autocall barrier has not been broken on any of the previous observation dates) the underlying equity index is down by 19% compared to the initial level, the investor would expect to get their capital back, as the capital protection barrier has not been broken, and 35% (7% p.a. for each year invested).

Product C – A growth autocall note with 5-year term that offers the investor a predefined return of 9% p.a. linked to performance of an underlying equity index (for example FTSE 100 index). The return is payable on the given observation dates if the underlying is at or above of its initial level (this is known as autocall barrier). The product C also has the same 65% capital protection barrier as Product B.

‘The key difference of an income autocall and capital protected note is that the returns of income autocalls are more predictable than holding the underlying index fund while the capital protected product provides safety in market declines without a significant trade-off for the upside. ‘

Benefits of including structured products in investment portfolios

Let’s consider two portfolios, a traditional balanced portfolio of 40% equities and 60% bonds and an adventurous portfolio that has 100% equity allocation, in three different market scenarios: bearish, sideways and bullish market. The assumptions are summarised in the table below.

If we simplify and replace the assets in a traditional portfolio with structured products, we can compare how both portfolios perform.

Balanced portfolio

It is important to ensure that the investor’s portfolio is aligned to their risk appetite. Therefore, in this example of the balanced portfolio the 40% equity allocation is replaced by an income autocall, and the 60% bond allocation is replaced by a capital protected product. The autocall will provide a potential income and add equity risk to the portfolio while the capital protected note will provide safety and potential capital growth.

Adventurous portfolio

A traditional adventurous portfolio holds 100% in equities. This can be replaced by 50% allocation to the Income Autocall and 50% allocation to the Growth Autocall, both linked to FTSE 100. Both autocalls add equity risk to the portfolio.

Source: Causeway Securities, for illustration purposes only

Balanced portfolio – 5-year return comparison of traditional portfolio and portfolio of structured products

Source: Causeway Securities, for illustration purposes only

Adventurous portfolio – 5-year return comparison of traditional portfolio and portfolio of structured products

Source: Causeway Securities, for illustration purposes only

The above simplified example of replacing the traditional assets in the portfolio with structured products with similar risk profile shows that the structured products portfolio may outperform the traditional portfolio in every market scenario.

For balanced portfolio, the outperformance is most significant in the Bearish scenarios where the protection feature is bringing the most value to the portfolio and giving up some of the very high potential returns boosts the returns of the portfolio when markets are down or flat.

Adventurous portfolios build with structured products may perform as well as the 100% equity portfolios over a longer period of time in a bullish scenario, but can significantly outperform the traditional portfolio when the markets are flat or down.

While most wealth managers would not replace all traditional assets in the portfolio with structured products, the examples demonstrate that the overall portfolio performance, especially during bearish or flat markets, may be improved by including structured products in the portfolio.

‘The overall portfolio performance, especially during bearish market conditions, may be improved by including structured products the portfolio.’

Conclusion

Structured products may be a good tool to add diversification into a portfolio as they may provide a level of predictability to the portfolio returns and, due to the asymmetric payoff profiles, they can be less correlated to the traditional assets. This means that, if the markets are flat or falling, structured products may significantly reduce the downside risks and improve the risk/return ratio of portfolios.

 

For more information about structured products and how our products could help you to diversify your clients’ portfolios, please contact us.

 

Important information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer, recommendation or solicitation to buy, sell, or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. The value of financial products can fluctuate depending on several factors, such as market conditions and the value of underlying securities. Any illustrations, forecasts or hypothetical data provided should be taken for illustrative purposes only, and not as a guarantee of future returns. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and prior to investing in any financial product or fund, you should contact your financial adviser. Furthermore, we urge investors to carefully consider whether the investment is suitable for their individual circumstances, risk tolerance, and investment objectives.

As with all forms of investment, there are risks involved with structured products, including those on our website.

It should always be understood that:

• Structured products are not suitable for everyone

• Past performance is not a reliable indicator of or guide to future performance and should not be relied upon, particularly in isolation

• The value of investment and the income from them can go down as well as up

• The value of structured products may be affected by the price of their underlying investments

• The potential returns of a structured and the repayment of money invested in a structured product depend on the financial stability of the Issuer and Counterparty

• Capital is at risk and investors could lose some or all their capital

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440) in the UK and is an authorised financial services provider in terms of the Financial Advisory and Intermediary Services Act (Act No. 37 of 2002) in South Africa. Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

 

How to diversify portfolios using structured products?

The key to mitigate the impact of market uncertainty and to reduce potential losses caused by market volatility is to have a well-diversified portfolio aligned to long term investment objectives.

Investing in a range of different asset types with exposure to different sectors, countries, currencies will help to reduce the investment risk the portfolio is exposed to. This is because different asset classes generally react differently to certain market events. Nevertheless, designing an effective and efficient diversified portfolio can be seen as a complex and intimidating task especially in the current market environment of volatile equity markets and rising interest rates, where the conventional 60/40 portfolio construction is no longer an adequate foundation for solid investment returns.

Diversified portfolios can help to reduce risk in volatile times

To mitigate the impact of market volatility and to ensure long-term growth, a well-diversified portfolio must include a sufficient allocation of assets deemed defensive in nature or assets that do not move consistently in tandem with other holdings in a portfolio. These could be assets, such as structured products, which are designed to provide a level of capital protection or predefined outcomes. The key benefit of structured products is that they may provide pre-agreed returns in flat and sometimes even slightly declining market conditions while ensuring that investor’s capital is safeguarded, partially or fully, in the long term.

Combining differing types of structured products in a portfolio may help to ensure you receive defined results irrespective of the market conditions. For example, structured products that offer fixed returns, may help to maintain a flow of income over an agreed period (monthly, quarterly, etc), whereas participation notes can enhance the positive exposure to any underlying while keeping the capital partially or fully protected until the end of the investment term.

Ensuring the portfolio meets investors risk appetite

Like other investment vehicles, different structured products bear different levels of risk. It is important to ensure the structured products selected are aligned to the investors’ risk appetite and complement their wider portfolio.

Including structured products in the investment portfolio may help to optimise its overall risk/return ratio as they may offer not only capital protection but also stability and a level of certainty over potential future growth.

An important feature of structured products is that they enable the investors to remain exposed to equity market performance without significantly increasing the risk of their overall portfolio. This may help investors achieve their investment goals which may otherwise be unattainable. In other words, the investment goal may not be achievable with a balanced portfolio while an adventurous all equity portfolio may be too risky for the investor’s risk profile.

Let’s look at what this could look like in practise

Please note these examples are for illustration purposes only and not based on real market events. Structured products are capital at risk products, meaning whilst they may offer full or partial capital protection this is not guaranteed and is subject to the default risk of the issuer.

Product A – A 100% capital protected note, subject to issuer default risk, that offers investors 110% participation in the performance of an underlying equity index (for example FTSE 100) at the end of a 5-year term.

In five years’ time, the investor would expect to receive their capital back plus 110% of the upward performance of the FTSE 100, subject to issuer default risk. The growth received will not include any dividend payments as structured products use dividends to increase the participation and to finance the capital protection.

Product B – An income autocall note with a 5-year term that offers the investor a predefined return of 7% p.a. linked to performance of an underlying equity index (for example European stock index). The return is payable on the given observation dates if the underlying is at 85% or above of its initial level (this is known as a coupon barrier). The product B also has a 60% capital protection barrier; this means investors will receive all of their capital back unless the market has fallen by more than 40% at maturity. In such a situation the initial investment will be reduced on a one-to-one basis.

If in five years’ time, on the last observation date (assuming the 100% autocall barrier has not been breached on any of the previous observation dates), and the underlying equity index is not down by more than 15% compared to the initial level, the investor would expect to receive their capital back, as the capital protection barrier has not been breached, and a 7% p.a. (plus any previously missed coupons for each year invested; a total return of 35%), subject to issuer default risk.

‘The key difference of an income autocall and capital protected note is that the returns of income autocalls are more predictable than holding the underlying index fund while the capital protected product provides safety in market declines without a significant trade-off for the upside.’

Now, let’s consider a traditional portfolio of 40% equities and 60% bonds in different market scenarios: bearish, sideways and bullish market. The assumptions are summarised in the table below. If we simplify and replace the assets in a traditional portfolio with structured products, we can compare how both portfolios perform. It is important to ensure that the investor’s portfolio is aligned to their risk appetite. Therefore, in this structured product portfolio example the equity allocation is replaced by an income autocall, and the bond allocation is replaced by a capital protected product. The autocall will provide a potential income and add equity risk to the portfolio while the capital protected note will provide a level of security and potential capital growth.

Source: Causeway Securities, for illustration purposes only.

5- year return comparison of a traditional portfolio and a portfolio of structured products


Source: Causeway Securities, for illustration purposes only

 

Source: Causeway Securities, for illustration purposes only

The above simplified example of replacing traditional assets in the portfolio with structured products, with a similar risk profile, shows that the structured products portfolio has the potential to outperform the traditional portfolio in every market scenario. The outperformance is most significant in the Bearish scenarios where the protection feature adds the most value to the portfolio.

While most wealth managers would not replace all traditional assets in the portfolio with structured products, the example demonstrates that the overall portfolio performance, especially during bearish market conditions, may be improved by including structured products in the portfolio.

‘The overall portfolio performance, especially during bearish market conditions, may be improved by including structured products the portfolio.’

Conclusion

Structured products may be a good tool to add diversification into a portfolio as they may provide a level of predictability to the portfolio returns and, due to the asymmetric payoff profiles, they can be less correlated to the traditional assets. This means that, if the markets are flat or falling, structured products may reduce the downside risks and improve the risk/return ratio of portfolios.

For more information about our structured products visit our Portal.

 

Important Information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price, or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

Income paying products – searching for yield in today’s environment

With inflation being at levels investors haven’t seen in forty years, and many investors seeking to preserve their capital whilst sustaining an income in this volatile, uncertain environment; traditional asset classes such as bonds are looking less attractive.

A combination of uncertainty and rising interest rates means that whilst the likely short-term decision might be to reduce their portfolio’s weighting towards bonds; the question is where should the investor move this allocation? An asset class which is certainly worth exploring is structured products, and more precisely, income paying structured products.

What is an income paying structured product?

Income paying structured products are financial instruments that can offer competitive levels of income, without compromising investor’s capital in a depressed market. Like other structured products, their performance is linked to the performance of their chosen underlying investment ‘the underlying’. The underlying can be for example a stock market index, a stock, or a basket of stocks.

The most common income paying structures

The most common structure is known as a ‘Phoenix’ payoff. This offers investors income (or yield) over a certain period as long as the underlying is above a specific pre-determined price level known as the income barrier. For example, a product will pay income on a quarterly basis over 6-years if the underlying investment is at or above 75% of the initial price level of the underlying on each quarterly observation date. This type of income paying structured product often includes a memory and autocall feature.

What is a memory feature? A memory feature enables investors to recapture any income payments that have been missed due to the underlying not meeting the pre-set price level, in the event that the price of the underlying recovers.

What is an autocall feature? An autocall is a feature which can trigger early maturity of the product, returning the investors’ principal in full if the underlying is at or above a pre-determined price level known as the autocall barrier.

The dates used to review the price level of the underlying for autocall purposes is not always the same as the dates used to review the price levels for income payments. For example, income could be paid quarterly, whilst the product may only have the opportunity to autocall annually.

How does a Phoenix Autocall payoff work?

An example of a Phoenix payoff is shown in the diagram below. On this example, the product would mature on the first autocall observation, after four quarterly income payments being made to the investor.

Source: Bloomberg 25.08.2016 – 25.08.2022

It must be noted that income paying structured products are capital-at-risk products. This means that if at the end of a product’s term the price of the underlying is below a pre-set capital protection barrier, for example, if the price level of the underlying falls beneath 65% of the initial level, the investor will not receive all their capital back, it will be reduced on a 1 to 1 basis with the performance of the underlying. However, if the price of the underlying is above the pre-set capital protection barrier, the initial capital amount invested is returned to the investor in full upon product maturity.

The other structure which is coming back into fold due to improving interest rates along with higher volatility is the ‘Reverse Convertible’ payoff. This structure offers the investor a fixed level of income, irrespective of the performance of an underlying, subject to the continued solvency of the counterparty issuing the investment.

How are income paying structured products priced?

The key components which determine how income paying structured products price are:

-Dividend yield of the underlying

-Interest rates

-Implied volatility of the underlying

The ideal condition for income paying structured products is a volatile underlying, with a high dividend yield, in a high interest rate environment. This means that the current rising interest rates are certainly making these products more appealing to the investor.

Why would you invest in an income paying structured product?

Income paying structured products can be attractive for investors who are looking for high levels of income and can accept some risk to the invested capital. These products allow investors to take advantage of higher market volatility to receive a pre-determined yield that is inaccessible through traditional fixed income securities, whilst protecting the initial capital from poor market conditions. However, the investor is exposed to the risk of a significantly large decline in the price of the underlying. Whilst this risk is not to be underestimated, the upsides of a competitive yield that is locked in over multiple years is certainly worth exploring as part of a wider portfolio.

If you want to know more about income paying structured products offered by Causeway Securities, visit our website and register to access our Portal to receive our weekly newsletter and up to date information about the latest products open for investment.

Important Information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice you should contact your financial adviser.
Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

Is this a new dawn for Capital protection?

Since the beginning of the year, it has been a rocky road for equity markets. The markets have been declining around the world due to inflationary concerns, rising interest rates and geopolitical problems. The Central banks have started to curtail the easy monetary policy by increasing rates whilst global economic growth optimism continues to hit all-time lows. This has seen investors starting to pull money from riskier assets and cash levels have risen to their highest levels in more than a decade.

As equity indices have lost up to 30% since the start of the year, the prices to enter the market are starting to look more attractive again with some industry experts such as CreditSights, the independent financial research company, suggesting stocks may be nearing a bottom as credit spreads have stabilised and are moving around less. However, due to higher volatility and continued uncertainty more and more investors continue to wait, and are overweight cash and underweight equity.

New opportunities

For structured products this new higher interest rate environment has created opportunities and enables us to provide investors access to equity markets via 100% Capital Protected Notes. These are packaged investment vehicles issued by a bank that use interest rates and dividends to provide capital protection and additional exposure in the price increase of equity indices.

Capital Protected Notes can be an addition to the portfolio of more cautious investors worth considering. For example, investors could potentially receive 120% to 140% exposure in the rise of a global equities while protecting 100% of their invested capital at maturity, subject to the issuer not defaulting on their obligations. This kind of investment can provide investors the best of both worlds, all or some of their money back if equities do not perform or high participation in rising equity markets.

How do Capital Protected Notes work?

Capital preservation is important and sometimes simple diversification does not do the trick. This can be especially relevant for people who need access to their investments and are nervous about market volatility.

To learn how Capital Protected Notes work, watch our animation video below.

 

If you want to know more about products offered by Causeway Securities, visit our website and sign up to our weekly newsletter.

 

Important Information

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell, or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice, you should contact your financial adviser.

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.

 

 

 

 

 

Decrement indices, a tool to reduce the uncertainty

Decrement indices have been purposely designed with structured products in mind. What the decrement feature offers is reduced uncertainty of hedging future dividends for the structured product issuer by instead fixing the dividend, and therefore reducing costs.

When banks issue a structured product that uses an underlying that does not include dividend income (like the FTSE 100), they must forecast a projected dividend and hedge out this projection using futures and options, which increase the costs and risks for the issuer. However, if the dividend for the underlying in a structured product is fixed then the bank will experience reduced costs and uncertainty from hedging the dividend, leading to improved product terms for the investor.

What is a decrement index?

Most equity indices come in two forms, price and total return. A price index, such as the FTSE 100, is an index which uses the market prices of the constituent securities, but excludes dividends paid by the securities. A total return index on the other hand, such as DAX, includes any dividends paid to investors holding the securities within the index.

The decrement index is a so-called synthetic index, which aims to replicate the returns of the equivalent total return index. The difference is that the synthetic index deducts a pre-fixed annual dividend (known as a “decrement”) on a rolling basis from the replicated total return index price.

Let’s look at few different FTSE 100 indices as an example.

• The value of the FTSE 100 price index is determined by the market prices of the securities forming the index excluding any dividends paid by these securities.

• The valued of the FTSE 100 Total Return Index is determined by the market prices of the securities forming the index, plus the dividends paid by these securities.

• The value of the FTSE Custom 100 Synthetic 3.5% Fixed Dividend Index (FTSE CSDI) takes the level of the FTSE 100 Synthetic Index (which has returns similar to that of the FTSE 100 Total Return Index), and then subtracts a fixed annualised 3.5% dividend (decrement) from the index level on a rolling daily basis.

Benefit to Issuers and Clients?

The advantage for the issuers is obvious: as the synthetic dividend is agreed in advance, there is no dividend risk for the issuer. Only the volatility risk remains.

By selling a structured product based on a total return index with a decrement, the issuer eliminates the unpredictability of dividends and is protected against any dividend shortfalls.

The reduced risk for the issuer can mean better terms for the investor on a synthetic index, which is designed to closely replicate the benchmark index.

This also allows banks to issue notes with longer maturities that may be more appropriate for long term investors.

Risks of decrement indices

The decrement index is not the same as the benchmark. While its performance is expected to be similar, it will not be identical. It is possible that the benchmark could rise while the decrement index falls.

Whilst the decrement indices can help to reduce uncertainty, the potential disadvantage to the investor is that the decrement index may underperform the total return or price index during periods of market distress; when dividends are likely to be reduced or stopped.

Sometimes decrements can also be set at much higher levels than the historical dividends of the underlying. This may help to increase the potential coupon (return) to the investor, but it also increases risk of underperformance (of the decrement index compared to the price index).

Closer look at correlation and past performance

If we look at the historical dividends of the FTSE 100 over the past 10 years and compare it to the FTSE CSDI (which subtracts a fixed annualised 3.5% “dividend”), this fixed dividend has largely worked in investors’ favour. This is because it has been lower than the annual dividend of the FTSE 100 in nine of the past ten years.

Historical annual dividends of the FTSE 100

Summary

Decrement indices are an effective tool for issuers to use as underlyings on structured products. Lower costs and risks for the issuer translates to improved terms for investors.

The risk of the decrement exceeding the annual dividend, resulting in potential underperformance is the core risk of using these indices. However, in return the investor should receive enhanced terms for bearing this risk.

The level of the decrement is key: setting it too high will likely result in underperformance versus the benchmark. The decrement level is typically set at around the historical implied dividend yield of the index.

 

Important Information

The FTSE CSDI is not seeking to replicate the FTSE 100 index. Instead, it’s an alternative that is expected to perform in a similar way, but which is appropriately designed as an underlying for structured products. You can find out more about the FTSE CSDI, including performance factsheets and daily index levels, at www.ftserussell.com/index.

This publication is intended to be Causeway Securities Limited own commentary on markets. It is not investment research and should not be construed as an offer or solicitation to buy, sell or trade in any of the investments, sectors or asset classes mentioned. The value of any investment and the income arising from it is not guaranteed and can fall as well as rise, so that you may not get back the amount you originally invested. Past performance is not a reliable indicator of future results. Movements in exchange rates can have an adverse effect on the value, price or income of any non-sterling denominated investment. Nothing in this document constitutes advice to undertake a transaction, and if you require professional advice you should contact your financial adviser.

Causeway Securities Limited is authorised and regulated by the Financial Conduct Authority. (FCA FRN 749440). Causeway Securities Limited is registered in England and Wales with company number 10102661. Registered address 2nd Floor 1 – 2 Broadgate Circle, London, England, EC2M 2QS.