Federal Reserve Chairman Ben Bernanke recently said the U.S.
central bank would spare no effort to boost weak growth and lower unemployment.
Almost three years ago, the Fed cut its benchmark
rates to near zero to pull the economy out of a sharp recession, and on August
9, 2011, it eased monetary policy further by expanding its earlier promise to
hold rates at rock-bottom levels for an extended period, at least through
mid-2013.
While these recent Fed decisions help maintain the housing
industry, they also present an opportunity.
Despite today’s low-yield environment, individual and institutional investors
continue to want higher returns as they balance risk versus reward, with more
yield compensating them for taking on more risk.
In today’s turbulent, low yield market, structured products
or market-linked investments are becoming increasingly more attractive to both
retail and institutional investors because they provide a compelling means of
enhancing and broadening investment portfolios.
Structured products are investments that include a derivative-linked
payout backed by the issuer’s credit. Different
forms include structured notes and certificates of deposit (CDs). They are distinctly different from
asset-backed securities (ABS) and mortgage-backed securities (MBS), which are
investments funded by a pool of loans.
Because ABS/MBS are called “structured finance,” “structured credit” or “securitization,”
the similar names can often cause confusion.
Traditionally, structured products have been more popular in
Europe and Asia. However, we expect their
popularity to increase in the U.S. because of three factors: today’s historically
low global interest rates; institutional investors “hunting for yield”; and an
available feature of built-in principal protection, which creates an attractive
investment for the retail sector.
In fact, according to a report in Investment News, $30 billion in structured products were sold in
the U.S. in the first half of 2011 as compared to $53 billion in all of 2010
and $33 billion in all of 2007 – which was considered a good year for the just
burgeoning structured products marketplace.
Fueling this growth is the ability of structured products to
offer customized exposure to the market and meet specific investor needs that
can’t be met by standardized market instruments. As such, they can be used as an alternative
to direct investments in equities in the S&P 500, mutual funds,
exchange-traded funds (ETFs) or market indices like the Morgan Stanley Emerging
Markets Index and as an asset allocation strategy to reduce the overall risk
exposure of a portfolio. They are frequently
offered as SEC-registered products, which make them accessible to investors
just like stocks, bonds, mutual funds and ETFs and are a useful complement to
those better-known products as part of a diversified portfolio. However, unlike mutual funds, ETFs and hedge
funds, structured products are created and offered continuously, with specific
maturity dates that can be personalized to meet a variety of investment
objectives.
The two general types of structured products that are both
principal protected and at the same time participate in some other market via
derivatives are market-linked CDs, which are bank accounts that pay a
derivative coupon, and structured notes, which are bonds that pay a derivative
coupon. In the latter group includes a
wide variety of structured products, such as equity-, interest rate- and FX and
commodity-linked single name notes, baskets and hybrid blends. Market-linked CDs are fully protected by the
Federal Deposit Insurance Corporation (FDIC) up to $250,000 per instrument, while
structured notes are guaranteed by the issuer, which includes many of the
world’s leading financial institutions.
A Guaranteed Return
with Reduced Volatility
Investors are attracted to structured products because they can
offer protection against market losses while offering higher yields, access to
specialized asset classes and tax advantages. The full FDIC protection of market-linked CDs
also makes them a very attractive principal-protected investment. Structured products are designed so they can
never lose the value of the initial investment, with the upside that if the
market goes up, they generate greater returns, and if the market goes down,
investors still receive all of their initial investment. In other words, they guarantee a return of at
least 100% of the original investment and have the potential to return much
more – while ensuring reduced volatility or risk.
Specifically, principal protection guarantees the investor
protection of principal if the note is held to maturity. For example, if an investor invests $1,000 in
a structured note with a face value of $1,000 with a five-year maturity, the
note actually consists of two components – a risk-free bond that will generate
sufficient interest to grow to $1,000 over the five-year period and a
derivative. With the money left over
after purchasing the bond at its original issue discount to face value, the
issuer can purchase another product that will match the investment
strategy. This may be swaps, options or
another type of derivative.
At maturity, the investor gets back $1,000 no matter what
happens to the underlying asset. If the
underlying value of the derivative asset is higher on the date of maturity than
when it was issued, then the investor also gains that higher return on a nearly
one-to-one basis. If it is not, then the
investor only receives the original principal-protected $1,000.
Mutual fund companies are increasingly looking at structured
products as long-term investments that can boost their firm’s offerings to
their customers. They can link a
structured product to one of their flagship funds, for example, giving them
another, new type of product that would increase their asset base.
Structured products can bring many of the benefits of
derivatives to investors that would otherwise not have access to them as part
of their investment portfolios. However,
with all investment products, it is vital that there is transparency so that
more investors have access to sophisticated strategies like structured products
in a safe and rational way. Our mandate as
an industry is to make sophisticated products and investment strategies simple,
accessible and understandable to all investors by driving down the barriers to
entry through technology and the promotion of standards.
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David K. Donovan is Vice President & Managing Director of
Sapient Global Markets, a business and technology services provider to the
capital and commodity markets. Previously, David Donovan was the Sector
Leader, Technology Group, at Fidelity Management & Research (FMR).
The preeminent trader at FMR, his vision and grasp of the intricacies of
the global market enabled him to make key decisions across Fidelity’s major
funds. Disclaimer: The views and opinions expressed here do not necessarily reflect
the views and opinions of Sapient Global Markets or any other company. www.davidkdonovan.com
