Even with interest rates starting to move up around the world, structured products are an increasingly key source of yield enhancement for p...

Even with interest rates starting to move up around the world, structured products are an increasingly key source of yield enhancement for private banks and wealth managers. These derivatives-based notes and other instruments also allow buyers to tailor exposures and risk/reward profiles to their requirements, providing investment packages that are both more precise and more convenient than cash markets can offer. Structured products usually trade in debt formats such as medium-term notes or Schuldschein, but may also be sold as warrants in some cases. They are available in every asset class, while key parameters—most importantly, currency, principal protection, final maturity and amortisation, call schedule and non-call period, and leverage—can be varied to an almost limitless degree. Compounding complexity Accordingly, the complexity of structured products ranges widely. At their simplest, they may be one-time callables, in which an otherwise vanilla note pays an above-market coupon for its credit, currency and maturity. This reflects an appropriate premium for the single interest rate call that the holder has sold. In this way, he is compensated for the risk that the note’s issuer will exercise its option on the call date if rates for the remaining maturity are then trading below the coupon level. From here, structured products extend all the way to multi-asset class hybrid plays. In these, coupons and/or redemption depend on the performance of two or more asset classes. Such instruments may also feature a quanto element, meaning that they are denominated in a currency different from their underlyings. Thus, a private bank managing money for Swedish kronor-based clients wanting exposure to potential upside in European equities but seeking downside protection might buy a quanto equity/inflation hybrid in SEK. Such a note could be structured as a zero-coupon in the Swedish currency that redeems at par plus a performance element linked to the Dow Jones EuroStoxx 50 index’s gains over the note’s life, with the final pay-off floored at the increase in the Eurozone Harmonised Index of Consumer Prices during the period. Similarly, the same private bank might consider a multi-asset class structure built on the strong correlation between the US dollar and global equity markets. This pays a somewhat below-market coupon so long as EUR/USD or another major USD cross trades above a barrier level; once the reference exchange rate trades below the barrier level, it switches to a zero-coupon structure on the Eurostoxx 50 or another equity benchmark (or a basket of indices). It then redeems at par plus the reference index/basket’s return over the entire life of the note, but capped at a predetermined level times the number of years remaining when the switch is triggered. Most interest in interest rates Key underlyings to structured products remain interest rates, equities and currencies. However, significant volumes also now trade in products linked to commodities, credit, funds and inflation. As in the equity/inflation and currency/equity examples above, structures involving combinations of two or more of these asset classes are increasingly important as well. Of these, interest rate-linked products account for as much as 70% of the international structured product market, which exceeded USD205bn-equivalent in 2004, according to data provider mtn-i. Their share varies somewhat between individual currency sectors, however (85% in US dollars, but 50% in Swiss francs and 40% in sterling, for example). The past year has seen two periods of intense new product development and growth in interest rate-linked structured products as structured note dealers and private banks have refined their distribution chain. “Our relations with private banks have deepened and distribution is functioning increasingly well,” comments the head of MTNs at one leading European bank in London. “Among Benelux actors, there has been a big switch around out of equity-linked and into interest rate products,” adds the head of new issues at a leading intermediary in Luxembourg. In the first period, which began during the first half of 2004, the classical range accrual structure was reinvigorated by a new focus on constant maturity swap spreads. Such notes typically pay the fixed or floating-rate coupons of traditional money market rate-based range accruals, with payouts accruing as usual on each day that the underlying rate trades within a pre-determined range. However, they are indexed to the spread between long and short-term CMS rates (30-year CMS minus 2-year CMS, for example) or long and intermediate term CMS rates (30-year CMS minus 10-year CMS, for example), rather than US dollar Libor or Euribor. Quite often, the range embedded in such notes has no upper barrier; in these cases, coupons accrue so long as the reference spread is at or above 0 per cent. Both above-zero and sub-zero barriers have also featured in more aggressive and defensive configurations of this version of the structure. Alternatively, such notes may indeed feature a range, but with a step-down lower barrier. This reflects the flattening or even inversion of the yield curve anticipated by the forward curve. The structure allows investors to express the view that the forwards exaggerate the likely speed and scale of future flattening. “Private banks in Switzerland have been buyers of CMS products, more so than Benelux banks,” reports the Luxembourg new issues head. In addition, the first half of 2004 also saw the emergence of cumulative inverse floating-rate notes or ‘snowballs’. After a fixed initial payout for the first six or 12 months, these pay a cumulative coupon of the previous coupon plus a fixed rate (which often steps up over the note’s life) less a reference rate such as US dollar Libor or Euribor. Again, their rationale is to give holders a way of expressing a contrarian view on rates compared to that implied by the forward curve. “The product offers a very, very high first coupon and has been especially attractive to private banks,” adds the head of interest rate derivative marketing at one major structured note dealer in London. More recently, the search for yield has driven a new round of still more complex interest rate-linked structures. These have tended to combine the basic components of range accruals and snowballs, both with each other and/or with other features such as target redemption. One of the resulting products, the range accrual snowball, accrues at a rate of the previous coupon plus a step-up fixed rate less the reference rate for each day when the reference rate trades within a pre-determined range. Payouts may be capped. Target redemption has been a popular feature in a variety of interest rate-linked structures (and also some equity and currency plays) since it first emerged in 2003. Unlike most other complex interest rate-linked structures, target redemption notes are not callable at the option of the issuer/swap counterparty but only by the activation of a trigger event. They give holders certainty about their ultimate return but leave the timescale over which this is achieved open. They do so through incorporation of a lifetime cap on coupon payments. This triggers early redemption once it is met. A lifetime floor at the same level as the cap guarantees the target return. Basking in credit Besides the particularly complex multi-asset hybrid plays illustrated above, other important structured products for private banks now include fund, credit, and currency-linked instruments. While funds have been repackaged into capital-guaranteed notes for some time, the current growth of demand for constant proportion portfolio insurance structures is particularly notable. CPPI notes create a dynamically-hedged position in the underlying fund. This sophisticated technique seeks to create a leveraged exposure to its upside while maintaining capital protection. “They are a more value-added structure than fund replication, so they are more attractive to private banks,” explains the head of equity and fund structures at one French bank. In addition, an increasing number of private banks are using credit overlays on a host of structured products. By accepting a credit risk—either that of a specific reference entity or a basket of credits - as part of the investment package, they are able to generate significant additional yield. Moreover, while the credit risk accepted may be unrelated to the structure’s fundamental investment view, it may also be closely correlated. One example is a basket note on a group of higher-yielding currencies versus the US dollar, with an additional first to default credit link to each currency’s sovereign. Providing none of the countries defaults during the note’s lifetime, the zero-coupon will pay out the currencies’ average return over this period; strengthening currencies should lower the risk of default. Often, all of the reference currencies/sovereigns will be Asian. This reflects the region’s strong growth prospects. Other undervalued emerging currencies such as the Brazilian real and Russian rouble may also feature in such baskets, both credit-linked and pure currency plays.