South Africa Performance Report 2019

Products Market Performance Review

South Africa 2019

Structured

Editorial: Nikola Nedev, Amelie Labbe

If you are interested in having a similar bespoke report produced for your organization, please contact Fabrizio Spagna at (44 207) 779 8505 or email Fabrizio@structuredretailproducts.com

Structured Retail Products (SRP), part of the Euromoney group of companies, is the leading online resource for the global structured products industry. With over 3,000 registered users and more than 20 million product listings covering over half a billion data points (as of February 2019), the website is the primary information source for a wide range of businesses involved in the manufacture and distribution of structured investment products.

October 2018 marks 16 years since the first product was listed our South African database. SRP has therefore decided to carry out an inhouse research report, with the primary source of information being the extensive product databases of StructuredRetailProducts.com.

This report provides an analysis of the performance of structured retail products distributed in

About SRP Methodology

Data collection and criteria

The performance data has been extracted from public sources such as issuer websites and submissions from market players. Additional performance data has been calculated in-house and is based on the performance of the underlying over the investment period.

The calculation of the performance takes into

South Africa that matured or expired between 2008 and the last quarter of 2018 (Q4 2018). The analysed data includes a total of 958 products and was compiled on the basis of the StructuredRetailProducts.com South Africa database, which covers over 1,700 products, of which 803 are live year-to-date.

What is a structured product?

The term structured product refers to an investment product designed to provide a return that is pre-determined with reference to the performance of one or more underlying markets. It is typically comprised of a bond and an option, with the former guaranteeing capital protection at maturity, and the latter protecting capital, achieving a higher return, or both.

account the capital return and all interest, fixed or variable, paid during the lifetime of the investment and at maturity.

As the local market comprises many products using foreign currencies, calculations were performed using the FX rates of the South African rand (ZAR) against other currencies to calculate a capital return in ZAR. This ensured accurate results and accurate representation of the data across all products.

While we calculated product performance in absolute terms, we deemed it appropriate to compare it to benchmarks that represent industry standards and/or investment choices investors might have made, had they not invested in a structured product. As such, for every single structured product, we selected a benchmark that the investor could have chosen on the initial date, and compared the performance of the benchmark during the life of the structured product until the maturity date.

Due to the diversified nature of structured products, where capital protection can vary, we decided to divide the structured products in two categories: capital protected and capital-at-risk.

A natural choice for any investment which is fully capital protected is a risk-free interest rate

Choice of benchmark Limitations

benchmark, so the investor can gauge their excess return above the risk-free interest rate. As such, for fully capital protected products, we have compared annualised return of the structured products with the equivalent SASW interest rate, up to a one-year term. Returns of capital protected products with longer terms have been compared to the equivalent interest swap rate of one to five years, depending on the maturity date of the products.

For the capital-at-risk products, we opted for the South African domestic benchmark FTSE/JSE Africa Top 40, as a high proportion of the products covered by this report will be equity-linked. The typically high correlations between equity index underlings should also make the local domestic index an acceptable benchmark when the product is linked to foreign equity indices.

The returns shown do not take into account management fees in the case of a life insurance or investment contract, nor custodial fees in the case of an investment in a securities account. In addition, returns exclude entry/arbitration fees in the case of a life insurance or investment contract, as well as the subscription fee in the case of an investment in a securities account and social and

tax levies. The study analyses only the products for which SRP has collected or calculated performance data.

The performance data is not evenly distributed across the analysis period, meaning that for some time periods there is more performance information than for others.

Performance analysis

- Structured products averaged an 8.59% annualised return between 2008 and Q4 2018.

- Only 4.18% of the analysed products had a negative return.

- Performance has been steady since 2011 but peaked at 16.42% annualised return in Q1 2017.

From all the products with performances, more than 78% of the products which matured between 2008 and Q4 2018 delivered a positive return at the end of the investment term (three years on average), according to SRP data. Close to half of the products (49%) returned 7% or more.

Only 4.18% of the analysed products delivered less than the initial capital, compared with 17.5%

which returned the initial capital at the term of the investment. Of this 4.18%, returns were between –1.3% pa and -22% pa, resulting in an average loss of – 7.19% pa.

When it comes to the historical performance, we can observe two distinctly different dynamics in the performance of structured products, notably before and after 2012, and before and after 2016.

Products coming to maturity before 2012 were largely affected by the global financial crisis but still provided earnings based on their average performance. Political instability was also a factor in 2012, but this quickly changed after the second quarter of 2012.

The years following 2014 saw a steady decline

in product performances, which was largely due to the corruption and instability that have threw South Africa into a recession. However, the market adjusted and in the second half of 2016 the market for structured products showed a rapid climb. This was largely due to the shift of the economy from trade and catering to investing in diversified securities by investors who wished to minimise risk.

Histogram of annualised performances (2008-Q4 2018)

ZAR v offshore structured products

Despite their ups and downs, offshore products - most of which are issued in US dollars - have on average performed well. Following the 2012 crises, performance of offshore products had a small shortlived rise before reaching low to negative levels in the period from 2015 to 2017. In 2017, however, they were able to show their values with performances reaching on average of 30% across the year. Products issued in ZAR on the other hand have had less fluctuations from the period of 2008 to Q4 2018. Up until 2017, ZAR issued structured products have performed on average at 7% but in the period

following the beginning of 2017, they showed a decline of 2% to 3% on average.

Looking at individual offshore product performances, the GBP performed in the opposite direction to the USD and the EUR after 2017. Instead of having a sharp rise in annualised capital return of 30% like the USD and 10% like the EUR, the GBP dipped to low and even negative levels in 2017 and 2018. This could largely be attributed to Brexit and the uncertainty that have caused the value of the GBP to decrease compared to the ZAR.

Capital protected products v capital-at-risk products

To ensure that we analyse the performance of these products correctly, we distinguish between two main structured product families, depending on whether the invested capital is guaranteed at maturity. With the former, investors recover 100% of their initial investment at maturity (except in cases of bankruptcy, default of payment or resolution of the issuer).

The latter, which has become the most common category due to the low interest rate environment,

typically delivers higher returns, but the initial capital is at risk and the investor may lose all or part of the original investment, depending on the performance of the underlying. Typically, these types of products offer conditional or partial protection against a decline in the underlying of typically 50%, 60% or even 90% at maturity, within which limit the capital is guaranteed. Beyond this threshold, however, the investor is exposed to the fall of the underlying. The protection itself is carried out through a socalled knock-in barrier, which is set at a level lower than the strike price. If the barrier is breached, the percentage of the initial capital returned at maturity will be determined by the performance of the underlying in relation to its opening level.

Capital protected products have accounted for the vast majority of maturities since 2011. This shows that the market typically prefers risk-free investments with exceptions in times of crises. In 2012, however, capital protected maturities in the sample gave way to capital-at-risk products. One of the main reasons for this shift was the low interest rate environment, which negatively affected the potential absolute return from fixed income products, including structured products. In such difficult market conditions, manufacturers tend to address investors in need of yield and

capital protection. This is done by developing capital-at-risk structures with soft protection in a way where the capital is protected as long as the underlying does not depreciate more than the predetermined barrier with the limitation being that the client has full exposure to the fall once the barrier is hit. In exchange, the investor will not only be able to receive the investment back but also get a high coupon if the underlying is above a predefined level. This is achieved by having products with longer maturities that have the possibility of redeeming early.

Maturities

Capital protected products

- Capital protected products averaged a 7.57% annualised return between 2008 and Q4 2018.

- 43.53% of the capital protected sample delivered 7% pa or more.

- Only 5.88% of the analysed capital protected products returned less than the initial capital.

Political instability has driven the issuance of fully capital protected products. Of the 954 products issued since 2014, 658 guaranteed at least 100% of the nominal invested. With exceptions in the first

half of 2012 and 2017, on average capital protected products have represented 65% to 70% of the market in terms of products.

Capital protected structures pulled through the post-global financial crisis period with decreasing average return of 2.68% and an average return of 3.87% during the recession in 2016. The market also saw a decline in 2017 due to South Africa’s credit rating being cut to junk status.

The tables below highlight a few characteristics of the sample, which broadly match the characteristics of

the overall capital protected market in South Africa. The sample is heavily weighted towards equities, 81% of which are linked to the FTSE/JSE Africa Top 40 Index. The index itself represents 64.7% of the capital protected products in the sample.

The sample is dominated by simple uncapped call structures that mostly offer full upside participation in the upside of the underlying asset.

Histogram of Annualised Performances: Capital Protected Products (2008-Q4 2018)

Historical performances of capital protected versus interest rates

structured products are strongly dependent on the issuer’s funding level, which is the interest rate plus the spread (risk) of the issuer. The spread itself depends on the issuer’s credit rating, which is highly correlated with their risk of default. This explains why yields delivered by capital protected products mainly depend on the issuer’s

credit risk, which is a function of its credit rating.

In 2012, interest rates reached an all-time low. This followed an upgrading of the issuers’ credit ratings which translated into higher level of funding. This also meant a higher spread of the products that matured in 2013 and 2014.

Capital-at-risk

- Capital-at-risk products averaged a 10.45% annualised return between 2008 and Q4 2018.

- 59.14% of the capital-at-risk sample delivered 7% pa or more.

- Only 1.08% of the analysed capital-at-risk products returned less than the initial capital.

ZAR 8.5bn of sales was gathered out of the matured capital-at-risk products in South Africa with maturity dates between January 1 2008 and December 31 2018.

The following tables highlight a few characteristics of the sample, which, as expected, broadly match the characteristics of the overall capital-at-risk market in South Africa.

Just over 87% of the products which matured between 2008 and Q4 2018 delivered a positive return at the end of the investment term (2.4 years on average), according to SRP data. A large

proportion of the products (59.14%) returned 7% or more, while 1.08% of the analysed products delivered less than the initial capital. Nearly 12% returned the initial capital at the term of the investment.

Histogram of Annualised Performances: Capital-at-Risk (2008-Q4 2018)

Historical Performance of Capital-at-Risk Structured Products (2011-Q4 2018)

Negatively performing products returned an average loss of 6.75% pa. All of the negatively performing products were concentrated around the year of the global financial crash in 2008. Since 2013, the yield of capital-at-risk products returned to pre-crisis level and continued to rise until 2017 reaching levels of over 16%. Meanwhile, structured

product typologies have shifted towards easily understandable payoffs, linked in their vast majority to indices, and able to better resist possible market drops and corrections. One reason behind these higher returns is the early redemption feature which allows to capture rising momentum in uncertain sideways moving markets.

Single indices dominated our sample, with 40 products linked to the Eurostoxx 50 and 31 products linked to the FTSE/JSE Africa Top 40. The postcrisis period was marked by a trend of simplicity

as far as the payoff mechanism was concerned, and a modification of the exposure by investing into optimised indices that reinvest dividends and subtract a flat rate percentage.

Autocallables

- With performance targets and possible scenarios known in advance, autocallables fared well in sideways markets.

- 81% of the early redemption events occurred on the first observation date, driving the South African autocallables ahead of the market globally (ex-South Africa).

- 38.89% of all autocallables recorded an average annualised return above 7%.

From the sample recorded, 38.89% of all autocallable products recorded an annualised return above 7%, with no products returning a negative performance.

Historically, early redemptions have occurred and continue to occur on the first observation date. In terms of their autocall frequency, early redemptions in South Africa have been ahead of the markets globally (ex-South Africa), with 81% of products registering an autocall event on the first observation

date, compared to 54% globally. Only 10% of the autocallables in South Africa reached organic maturity, compared to 17% recorded globally.

It should be noted, however, that the investment term of autocallable products is generally long enough to allow the underlying to absorb possible unfavourable market cycles from the start, and to give it time to benefit from a possible subsequent rise in the financial markets.

(ex France) South Africa Autocallables

Historical performance of the capital-at-risk sample v FTSE/JSE Africa Top 40

We observe a positive and high correlation between the performance of the equities markets and the performance of capital-at-risk structured products. However, we note a case in which structured products tended to over-perform markets, because they were able to secure yield even during periods of market downfalls, which helps avoiding uncertainty stemming from sideways moving markets.

During the peak of the financial crisis in 2012, investment in both FTSE/JSE Africa Top 40 and the capital-at-risk structured products had lower

returns than normal with capital-at-risk structured products affected by a stronger downwards dynamic. Since then and up to 2014, both structured products and the FTSE/JSE Africa Top 40 returns stabilised. In 2014, however, the FTSE/JSE Africa Top 40 in contrast to the capital-at-risk structured products began to fall dramatically largely due to the political instability and the recession in South Africa. The diversified portfolio of the capital-at-risk structured products, however, was the main factor which helped them not to reflect the local market and protect investors from losses.

Do structured products deliver on their promise?

The most common myth about structured products is that they do not deliver any returns. What we conclude from this report is that structured products have delivered positive returns to investors in South Africa over the last 10 years.

Despite the positive correlation between the performance of equities markets and structured products, we observed that the latter were are able to outperform the financial markets, specifically when these were moving sideways or were bullish.

 Capital protected products weathered both global financial crises and South African political instability, managing to preserve invested capital. The drop in average return in 2012 was fully in line with the falling interest rates. Since 2013, and in spite of small drops, returns have stabilised, influenced by issuers’ increased funding level.

 Capital-at-risk products were affected by the crisis in 2012 with a number of products returning less than what was expected. Products offerings have since shifted towards more transparent and diversified portfolios, with the aim of being better understood by investors, and to withstand possible dips and corrections in the market. Since 2013, returns have risen, with structured products showing their value when local markets were affected as the South African market in 2017. There have not been any products since 2013 that have returned annualised capital return of less than 5% on top of the initial capital.

We can conclude that structured products can secure and greatly enhance South African investor returns, compared with directly investing in the underlying. Principal protected structured products can deliver returns which on average have outperformed a risk-free rate investment over the period of the analysed sample.