USA Performance Report 2007-2018

Structured Notes Performance Review USA 2007-2018

Editorial: Veselin Valchev, Tiago Fernandes, Amélie Labbé

Design: Paul Pancham

Marketing: Nimicha Bhanabhai

If you are interested in having a similar bespoke report produced for your organisation, please contact Joe Burris at +1 212 224 3458 or email Joe@structuredretailproducts.com

Introduction

This report is compiled by Structured Retail Products (SRP) using the extensive proprietary databases of StructuredRetailProducts.com. No single financial institution or body has commissioned the report which is completely independent in its sources, calculations and findings.

As the leading independent resource for the global structured products industry, SRP is focused on the industry’s wellbeing. As such, SRP put together this report to improve education and knowledge in the sector, which would allow the industry to grow and develop, and by extension deliver better results for investors.

This report is useful to all stakeholders in the industry, including issuers of structured products, distributors, investment advisors, index providers and regulators.

The paper looks at the investment returns obtained by investors in structured products sold in the US, including only products wrapped as registered notes, and those that have matured or expired in the 12 years to the end of 2018.

Who is SRP?

Structured Retail Products (SRP), part of the Euromoney group of companies, is the leading online research resource for the global structured products industry. With around 3,000 registered users and more than 22 million product listings covering over half a billion data points (as of May 2019), the website is the primary information source for a wide range of businesses involved in the manufacturing and distribution of structured investment products.

What is a structured product?

The term structured product refers to an investment product designed to provide a return that is predetermined with reference to the performance of one or more underlying markets. A structured product is typically comprised of a bond and an option, with the former to guarantee capital protection at maturity, and the latter to achieve a higher return.

The report will offer a breakdown of the performance of US structured products wrapped as registered notes that matured between 2007 and 2019, going in further detail on the following chapters:

• Management summary;

• Methodology;

• Limitations;

• Performance analysis of the US structured notes market;

• Capital-protected product performance analysis;

• Capital-protected products’ performance versus the equivalent risk-free interest rate;

• Capital-at-risk products performance analysis;

• Analysis of autocallable product returns;

• Capital-at-risk products performance versus S&P 500; and

• Do structured products deliver what they promise?

Methodology: data collection and sample criteria

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 the performance (84% of the matured products in the database).

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

Choice of benchmark

While SRP 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 market-linked note. As such, for each individual product, SRP included a comparison with the performance of the benchmark investment with the same time period.

A natural choice for any investment in which no risk is taken is a risk-free benchmark, so the investor can gauge their excess return above the risk-free interest rate. SRP analysed and compared each individual annualised return of capital guaranteed products with a term of up to one year with the Libor interest rates. Returns of capital guaranteed products with longer terms were compared to interest swap rates of two to 10 years against six months, depending on the maturity of the products.

SRP opted for the broadest of the mainstream US domestic benchmarks in the S&P 500 (total return) to compare capital-at-risk products, as a high proportion of the products covered by this report is equitylinked (97%). The typically high correlations between equity index underlyings should also make the local domestic index an acceptable benchmark when the underlying is linked to foreign equity indices.

Limitations

The returns shown are gross. The study analyses only products for which SRP has collected or calculated performance. Out of the 72,368 market-linked notes that matured or expired in the US in the period from 2007 to the end of 2018, SRP collected or calculated performances for 39,189 (or 54.15%). From those, 38,151 are principal-at-risk products, representing 54.77% of all maturing principal at-risk products, and 1,072 are principal protected products, representing 39.48% of all maturing principal protected products (the majority of the principal protected structured products in the US are not wrapped as registered notes).

The above-mentioned data reflects the performances of 148 different payoff structures, as well as 1,755 unique sets of underlying assets and 37 issuing entities.

Performance analysis

The average annualised performance of market-linked notes that have matured in the US since 2007 is 4.36% per annum.

Forty-one percent of products generated an average return of over 10% per annum.

Seventeen percent of products generated negative returns, in small part due to the global financial crisis; less than 11% of products maturing since 2010 lost capital.

Average performance since 2010 is 7.26% per annum.

Just under 80% of all market-linked notes that matured or expired in the 12 years to the end of 2018 generated positive returns for US investors, SRP data shows. The global financial crisis of 2008/9 had a profound impact on investors in US structured products, with over 46% of all market-linked notes that matured in the two years to the end of 2009 generating negative returns for investors. In contrast, less than 11% of products maturing after January 1 2010, lost money. Moreover, nearly 80% of products generated over 5% annualised returns for investors, and over 40% generated more than 10% per annum.

Over the entire period, the products that lost money lost an average of just under 25% of the capital per annum (or about 23% of the capital overall). Prior to the end of 2009, this figure stands at 37% per

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annum, and after that date, 15% per annum. A total of four products lost their entire invested capital over the observed period.

At the other end of the spectrum, products that did generate money for investors generated an average of 11.19% per annum. Notably, in the two years before the end of 2009, positive performances averaged returns of 15.06% per annum, while post-financial crisis, this figure stands at 10.85% per annum.

Generally, more standardised structured formulas, supported by rising equity markets, delivered stronger performances overall, despite consistently low interest rates throughout most of the period. Post-crisis, returns have been moderate to strong overall, excluding a small interruption in 2016 when markets were affected by the Chinese stock market crash and the collapse in oil prices.

Capital-protected products v capital-at-risk products

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

The second category, which dominates the registered notes market in the US, would typically deliver higher returns, but the initial capital is at risk, and the investor may lose all or part of the originally invested capital, depending on the development of the underlying. Generally, these products offer conditional protection against a decline in the underlying by typically 30% to 40% or even 50% at maturity, within which limit the capital is guaranteed.

Capital-protected products accounted for less than 3% of the overall volume of maturing registered notes over the entire period, and never held more than 5% of the volume for a single observed year. When investing in capital-guaranteed structured products, the US market generally tends to buy certificates of deposits (CDs) instead of notes.

Beyond that, the low interest rate environment has made it difficult to allocate resources for buying options at inception. Many of the at-risk registered notes, however, still address the need for both yield and capital protection by developing defensive capital-at-risk structures aiming to offer a return in slightly increasing to neutral or even bear markets. This has been widely achieved with the use of the autocallable mechanism whereby products with longer maturities can be redeemed early. We will elaborate more on the autocallable payoff further in this report.

Capital-protected products

Capital-protected products outperform when their return is null, as generally a direct investment on the underlying would mean a loss of capital.

On average, capital-protected notes outperformed their equivalent risk-free interest rate by 1.48% per annum.

Single index-linked notes, with a market share of 64%, returned on average 3.94% per annum.

Issuers’ increased level of funding in the post-crisis period led to a higher spread and outperformance of other risk-free investments.

SRP analysed 1,072 matured capital-protected notes in in the US with maturity dates between January 1 2007 and December 31 2018. These products initially gathered $12.2 billion in sales and delivered an overall average annualised return of 3.25% when they matured.

Histogram of annualised performances: Capital-protected products (2007-2018)

Just over 35% of the products in the analysed capital-protected sample returned the initial investment only. Meanwhile, over a third delivered annualised returns of over 5% per annum.

Capital-protected structures delivered over 1% annualised return in each of the observed years, with the sole exception of 2009, when returns averaged 0.63% per annum. We will explore the performance of protected notes compared to their underlyings, and compared to a risk-free benchmark further in the report.

The tables below highlight a few characteristics of the sample, which broadly match the characteristics of the overall capital-protected note market in the US.

The sample is heavily weighted toward equity indices which underlie 82% of the market, with stocks a distant fourth at just over 3% of the market. The predominant indices are the S&P 500, which underlies over 52% of the protected notes market, the Nikkei 225 at 20%, and the DJ Industrial Average and Eurostoxx 50 with 17% each.

Commodity underlyings are mostly exhausted by crude oil, gold and industrial metals, while emerging market currencies versus the US dollar, namely the CNY/USD and INR/USD, dominate the FX rates standings.

The sample is dominated by simple uncapped call structures offering, in most cases, full but not too leveraged participation in the upside performance of the underlying asset, with an average participation rate 111%. Capped call structures have offered a slightly higher participation, with an average of 115%, but have historically delivered much stronger results than uncapped structures, despite the presence of a maximum potential gain, which is attributable to stronger underlying selection.

Meanwhile, enhanced tracker and knock out (autocall) structures have delivered the strongest results, due to a more leveraged upside exposure and the capacity to deliver substantial upside from even marginal upticks in the underlying assets, respectively.

Capital-protected structured products are strongly dependent on an 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 yield delivered by capital-protected products primarily depends on an issuer’s credit risk, which is a function of their credit rating.

The post-crisis downgrading of issuers’ credit ratings has translated in higher levels of funding, which resulted in a higher spread for the products that matured in 2013 and from 2015 onwards.

Given that almost 70% of the products in the analysed sample had an actual investment term between six and 10 years, combined with buoyant equity markets post-crisis, this explains why products maturing at these periods have clearly outperformed the interest rate.

When compared with the performance of their respective underlying (for the same period as each of the observed structured products – like-for-like) the chart above demonstrates one of the key strengths of structured products in general – their capacity to safeguard capital. While underperforming in times of strong equity runs, guarantees over capital have saved investors nearly $1 billion in potential losses in the two years to the end of 2009 alone.

Capital-at-risk sample

Capital-at-risk products averaged a 4.46% annualised return between 2007 and 2019.

Seventy-four percent of the capital-at-risk sample delivered 5% per annum or more.

Seventeen percent of the analysed capital-at-risk products returned less than the initial capital.

Equity index-linked notes, with a total market share of 69%, returned on average over 7% per annum.

SRP analysed 38,151 matured capital-at-risk products with maturity dates between January 1 2007 and December 31 2018. These products initially gathered $17 billion in sales and delivered an average annualised return of 4.36% when they matured.

Eighty percent of the capital-at-risk products which matured between 2007 and 2019 delivered a positive return at the end of the investment term (0.6 years on average), according to SRP data. The vast majority of the products (73.8%) returned 5% or more, while 17.4% of the analysed products delivered less than the initial capital. Just over 2.5% returned the initial capital at the term of the investment.

In the two years to the end of 2009, 40% of all capital at-risk registered notes generated negative returns for investors, while after that the figure stands at less than 11%. Positive performances were also split with 57% of products generating 5% of more annualised return at maturity for the pre-2010 period, compared with 79% after that.

Histogram of annualised performances: Capital-at-risk products (2007-2018)

The at-risk segment of the notes market in the US also doesn’t stray too much from the equity space, but unlike the protected segment, shares were much more popular, particularly in the run-up to the financial crisis. As such, shares have underperformed over the entire observed period. However, after 2009, the average annualised performance of shares stands at 3% per annum, out of 15,228 maturing products.

Commodities, the only other major underperformer among asset classes, exhibited a more acute and consistent underperformance throughout the observed period, with a negative 0.3% return through the end of 2009, and negative 4.2% per annum after.

On the other hand, indices have generated significant returns throughout the period, with close-to neutral returns pre-2010, and just under 8% per annum afterwards.

Four of the top five underlyings are indeed indices, with the US market-tracking indices well ahead of the Europe and Global Developed Markets benchmark in the Eurostoxx 50 and the Russell 2000.

The vast majority of products are centered on a few structuring themes: tracking (either enhanced, protected or both), income (either fixed or contingent) and early redemption.

Barring vanilla reverse convertible and enhanced tracker products, all other major structures delivered returns of over 6.5% per annum, in the years after 2009. Prior to that, the reverse convertible was the most popular payoff, accounting for over 92% of the number of maturing products.

The reverse convertible, however, generated on average the worst results among the top 15 payoff structures. This is mostly due to the popularity of the structure in the run-up to the financial crisis, with a total of 6,087 reverse convertibles maturing in the two years to the end of 2009, returning negative 8.6% per annum. Since 2010, the structure has still underperformed, however, with 8,685 products returning on average just 0.5% per annum.

Autocallable products offer the capacity to exploit market rises while limiting their losses in the way of knock-in conditional protection barriers. The structure usually requires only marginal or no growth

at all in the underlying asset (measured from the initial strike date) to provide its target returns, while contingent coupon structures (which are often combined with an autocall feature), also allow the target income to be achieved even in bearish scenarios. The capacity to outperform in the full spectrum from slightly-bullish to slightly-bearish environments, in addition to the potential of early redemption, makes autocallables one of the most popular structures in the current environment.

Autocallables

These generated average returns of 8.49% per annum.

Seventy-three percent of the early redemption events occurred on the first observation date, pushing US autocallables well ahead of the global market:

– Sixty percent of successful first-observation autocalls were after one quarter; 22% after six months and 14% after one year.

– The average term for US autocall notes is 0.57 years.

Ninety-one percent of all autocallables recorded average annualised returns of over 5%.

Autocallables accounted for 59% of all capital-at-risk maturities in 2018 – the most of any other single payoff, generating average returns of 8.55% per annum, just a single basis point above the overall 2018 average.

Over the entire observed period, just 3% of all autocallables delivered less than the initial capital at maturity. The negatively performing products returned on average a loss of 15% per annum. Meanwhile, positively-performing products returned on average 10.1% per annum.

Notably, nearly three quarters of all autocall products matured on the first possible date, returning on average 10.29% per annum, but a full 11% reached organic maturity, returning on average a loss of 2.37% per annum.

Histogram of annualised performances: Autocallables (2007-2018)

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Historical performance of the capital-at-risk sample v S&P 500 total return

Average Performance of Structured Products

Average Performance of S&P 500 Total Return (like-for-like)

We observe a positive and strong correlation between the performance of the equities markets and the performance of capital-at-risk structured products.

A dominant feature of the products issued in the post-crisis period has been their ability to optimise the risk-return profile rather than to outperform the market they are linked to. With performance targets known in advance, the vast majority of products generally do not aim to outperform the equity market (in spite of being linked to equities). This is in line with the typical autocallable product, which might offer a set return of around 7% per year as long as the index remains stable or exceeds its initial level on any anniversary date.

This will translate into an underperformance against equities when those rise above the set return, though in the interest rate environment of the last few years 6% to 10% per year would be considered a very strong absolute return.

In this context, the below chart showcases these features, whereby structured products tend to dampen the downside exposure to their underlying market, while simultaneously underperforming in times of strong bull runs.

We observe a very strong correlation between the S&P 500 total return and the aggregate of the underlyings for all at-risk registered notes, with a correlation of 0.90.

While over the entire period at-risk notes underperformed their underlying with 4.42% return per annum, versus 10.57% per annum, when the underlying assets were on the down at-risk products mitigated losses with an average return of negative 2.67% per annum versus the underlyings’ return of negative 4.96% per annum.

Do structured products deliver on their promise?

The most common myth about structured products is that they do not deliver any returns. A key conclusion from this report is that structured notes have delivered positive returns to investors in the US over the last 12 years.

With an average return of 4.36%, that includes the extreme negative performance during the global financial crisis, the results showcase the capacity to deliver what they promised:

• Forty-one percent of structured notes generated an average return of over 10% per annum, showing that these products deliver a positive and high correlated with equity markets performance.

• Although 17% products generated negative returns, most of these structured notes delivered a higher return compared with a direct investment in the underlying.

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

Products with an early redemption feature (autocallables) work-outs have been performing well in the current environment of low interest rates and moderate volatility. Almost all of the top performers in the study were autocallables which had their early maturity features triggered, usually after one year of investment (particularly in periods of strong equity rebounds).

We can conclude that structured products can secure or even enhance US investor returns, compared with directly investing in the underlying, or the case of principal-protected structured products deliver returns which on average have outperformed a risk-free rate investment over the period of the analysed sample.

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