Structured products: sweet dreams are made of these

The past six months have been a nerve-racking ride for even the most seasoned investors. The global credit squeeze and potential US recession have sent shares tumbling, along with the fortunes of many.

However, if you’re like the 70 per cent of planners we recently surveyed who are expecting modest to high growth from Australian equities this year, you’re probably evaluating the best way to access buying opportunities.

As your clients reach for the motion sickness tablets before jumping on the roller coaster of equities investing, it’s worth taking a look at a new breed of protected structured products.

What is a structured product?

Structured products aim to provide exposure to a variety of asset classes, including equities, and may offer capital protection, leverage, or a combination of both. These products offer your clients the ability to invest in a wide range of asset classes, including asset classes you may not normally be able to access.

Often, these products also allow you to borrow up to 100 per cent of the investment amount, without the worry of margin calls. Combine this with the comfort of capital or loan protection, and you can see why they are attractive to a wide variety of investors.

What is a capital protected product?

Many investors (and their planners) struggle to understand how structured products are put together, especially how it is that they can provide protection. In simple terms, manufacturers of these products achieve these goals in a variety of ways. Three of the most commonly used methods of providing protection are:

1. Put options

Put options give you the right to sell a security for a certain price at a set date in the future. This means you can invest in shares today and take out an insurance policy that will ensure you receive no less than a certain price for these shares in the future, regardless of how they perform.

Put options are a popular tool for ‘insuring’ shares or portfolios. The benefits of investing in a product that combines a put option with an asset is that investors can retain beneficial ownership of the underlying securities, and therefore maintain entitlement to dividends and franking credits.

2. Zero coupon bond and call options

Combining zero coupon bonds and call options is a more recent approach to capital protection structuring, and more often used to protect international asset classes or indices that do not pay dividends. The call option, which is the right to buy an asset at a certain price at a date in the future, gives investors exposure to the capital growth of the underlying investment, but generally not the dividends or franking credits (if any). These calls are combined with zero coupon bonds, which guarantee the return of your capital at maturity.

As the name suggests, these bonds don’t pay coupons (i.e, yield). Instead, the amount you pay today is a discount to the face value of the bond, with the discount being equivalent to the present value of the coupons that the bond might otherwise pay. The longer the term of the bond, the cheaper the bond is at inception. For every dollar you invest, structured product manufacturers will invest in a zero coupon bond, and then use the remaining funds to buy you exposure to the asset or investment via call options.

Let me give you an example. A five year zero coupon bond may hypothetically cost around $0.62 ($1 minus 7.5 per cent interest over five years) and is guaranteed to pay you $1 in five years. That leaves you with $0.38 to invest in call options.

Depending on the price of the call options, you may be able to gain greater than 100 per cent exposure to the underlying asset (i.e, you may be able to purchase more than one call option per unit). The amount of exposure you receive to the underlying asset is known as your participation rate, and is expressed as a percentage of the face value of your investment.

Structured products that use zero coupon bonds and call options tend to be longer-dated to maturity to ensure there is sufficient capital left over from each dollar invested in the bonds to invest in call options (i.e, to ensure a high enough participation rate from the asset).

With bond plus call structures, you know from the start what your participation rate will be (i.e, you know exactly how much exposure you will get to the underlying asset at maturity).

3. Threshold management

Another mechanism used to provide capital protection in structured products is a derivative of the previous method called threshold management. Threshold management involves the manager starting out with a greater exposure to the investment asset and switching to bonds if markets fall. The strategy aims to maximise your clients’ exposure to rising markets. If markets fall significantly, investors’ capital is drawn down from the investment’s exposure entirely and invested fully in zero coupon bonds, which protects their capital until the investment matures. Participation rates using this form of structure will vary during the investment term, as there is a more active approach applied to the management of the structure.

While this is a fairly simplistic view of how structured products work, most products in the market use one of these techniques, or a derivation of these techniques.

What to look for before investing in a structured product?

At Macquarie, we believe there are four key areas investors should pay close attention to when evaluating structured products. The first is transparency. It’s essential your clients understand what they are investing in. They should appreciate how the structure works, the nature of the underlying investment, the costs and, of course, the risks.

Second, focus on quality. While many of these products offer attractive tax efficiencies, it’s important your clients pursue the main game: positive returns from quality underlying assets.

Third, we encourage investors to seek liquidity. In volatile markets, the ability to access your capital and walk away from your investment is critical.

And finally, evaluating the product provider is important. Check their credentials are sound and they have the necessary experience in structuring products with protection.

Pia Cooke is associate director in the Macquarie Equity Markets Group.