Best of Both Worlds

Absa’s range of structured solutions offers an attractive mix of capital protection and access to various asset class exposures. How do they work, and what role could they play in your clients’ investment portfolios?

Nobody likes to lose money – especially not investors, who understand the market’s inherent risk/returns trade-off, but still want some assurance that they’re going to get out at least what they’re putting in. Structured products offer exactly that, providing access to various asset class exposures along with a level of capital protection.

So why isn’t everybody demanding that these types of investments form part of their portfolio?

Probably because most investors don’t know very much about them.

“Historically these products were mostly accessed by high- or ultra-high net worth clients,” says Johann Gunter, Head of Distribution: Retail, Structured Solutions at Absa Corporate and Investment Banking. “There’s much wider use of these products now than there was, for example, 10 years ago, and that’s a direct result of how much the products have evolved over that period. Structured products are much more accessible now, and we can provide a solution for a much wider range of investors – from individuals to corporates and trusts – with onshore and offshore options that can be accessed on multiple platforms. Increased demand for these products has led to lower minimum investment amounts, cost efficiency and therefore increased allocation to these innovative solutions within investors’ portfolios.”

Johann Gunter, Head of Distribution: Retail Structured Solutions

HOW STRUCTURED PRODUCTS WORK

Structured products have the ability to deliver on the dual promise of capital protection and market-linked returns through the basic construct of a zero-coupon bond with a call option. “Take a basic example of a Five-Year Note tracking an equity index with capital protection at maturity. First you have to solve for capital protection, and we do that in the form of a zero-coupon bond,” Gunter explains. “We’ll go to the bank treasury and say, ‘If we want R100 back from you in five years, how much do we need to give you today?’ If that’s R70, for argument’s sake, we’re left with R30 to buy exposure to an underlying equity index. We do this by buying a call option, which gives us our upside in the index. These two instruments are then delivered in the form a Note issued by the bank.”

For investors to enjoy the full benefit, they must remain invested for the full term (typically five years). “If you exit early, your zero-coupon bond won’t have pulled to par yet,” says Gunter. “Depending on the performance of the underlying equity index, that call option might be in or out the money – and that would affect the value of that investment at any given time in the market. That’s why these products are structured to term.” The most basic structured products are guaranteed plans, where – as Gunter puts it – “you invest, say, R100 000 and after five years you’re guaranteed to back a percentage of growth on that money, no questions asked”. Guaranteed income or guaranteed growth plans are not linked to equity, they provide full capital protection, and they have a secured return at a future date. Johann Gunter, Head From that basic construct, structured products of Distribution: Retail have evolved to shape, diversify – and potentially Structured Solutions increase – their pay-off from risk assets (like equities). “A very basic structured product like this would give you full capital protection after five years, together with the upside of an equity asset (for example, an index like the FTSE/JSE Top 40 or S&P 500),” Gunter says. “So if things do not go well over the next five years – let’s say we have a major financial crisis, where your traditional equity products participate fully in that downside – the structured product would still have a floor. Its capital protection means that you can’t get out less than you put in.”

LIQUIDITY AND DIVERSITY

For financial advisers, structured products offer a very useful planning tool, especially if they are included as an allocation (some advisers recommend up to 25%) of the investor’s portfolio. “Some people make the mistake of looking at structured products as standalone products,” says Gunter. “Instead, they should be seen as building blocks in a client’s portfolio. As a financial adviser, you can allocate to these products depending on your client’s risk profile, or you could use a combination of structured products. In terms of equity exposure, it makes sense to diversify geographically and into different sectors, but it also makes sense to diversify the pay-off you get from those equities. A structured product is a useful building block because it could have a different pay-off than the rest of the portfolio.”

WHAT IS A STRUCTURED PRODUCT?

Structured products are linked to the performance of a stock, index, ETF, commodity, interest rate or currency (known as the underlying). A structured note is a debt product whose return is linked to the performance of the underlying assets or benchmarks. Examples include:

• Income Notes, which provide an annualised return on the investor’s principal. Investors receive a fixed coupon payment that is paid out over the life (or the term) of the note.

• Growth Notes, which aim to profit from positive movement in the underlying, while providing a level of downside protection.

• Digital Notes, which offer investors a fixed return on their principal at maturity, aiming to provide a more certain return outcome that is not dependent on the investor’s participation rate in the underlying.

In terms of geographic diversity, Absa’s range of offshore products includes a rand products with FX exposure on the returns. “The rand tends to depreciate over time against major hard currencies like the dollar, so it makes a lot of sense to give clients a hedge against that by enhancing their returns if the rand does depreciate,” Gunter says. “Our off-the-shelf offshore USD range includes a defensive product which gives 95% capital protection in US dollars, with 120% upside participation in a global equity index. Typical investors are clients who are sitting in dollar cash looking for an alternative, or clients who don’t want to risk their capital.”

Liquidity is another key factor. While structured products have set terms, investors can exit at any point. “If your financial situation changes and you need to exit, you can do so – and you do that at the mark to market value, or the fair market value of the underlying note based on its current market price,” says Gunter. That could result in some capital loss – not through any exit fees, but rather because of the value of the note in the market at that given date.

A TRUSTED ISSUER AND BANKING PARTNER

Key to this all is understanding that structured notes are debt instruments issued by a bank. The credit risk is that of the issuer, which is why it’s so important that the investor is comfortable with the bank as the issuing entity.

“You need to be comfortable that the bank will be around for the next five years,” says Gunter. “If you buy a structured note and the issuer goes insolvent, you’re going to lose some or all of your money. You are dependent on that issuer being able to fulfil its obligations in terms of the investment in five years’ time. That’s why credit risk and credit ratings are so important.”

To illustrate his point, Gunter provides a comparison between buying the same structured product from a Tier 1 global bank versus a Tier 3 bank. “If there’s a difference in the credit rating between the two banks, you will see it in the terms on offer,” he says. “The Tier 3 bank will give you better terms because there’s a credit spread, so it’s cheaper for them to provide the capital protection and they therefore have more money to spend on the option. But while you may get better terms from the Tier 3 bank, you’ll be exposed to more risk because the bank doesn’t have the same credit risk as the Tier 1 bank.”

Absa, for the record, issues all its Notes as senior unsecured debt instruments. This means that in the highly unlikely event that the bank were to experience some financial difficulties or even go out of business, the clients who hold the bank’s notes would have higher likelihood of recovering some or all of their capital compared to subordinate debt Note holders.

Through its partnerships with major international investment banks, Absa can offer a full suite of solutions. And while it is the credit issuer for most of its structured products, the bank also provides clients with access to major international banks’ structured product offerings. “When you deal with Absa CIB you’re not just working with our products and innovations,” says Gunter. “We give you access to the best of what’s available globally.” •

BENEFITS OF INVESTING IN A STRUCTURED PRODUCT

• Known return profiles: The payoff profile of each investment is clearly defined upfront and remains for the life of the product.

• Capital protection: When markets do not perform well and deliver negative returns, capital protection can offer reduced downside exposure at maturity.

• Potential for enhanced returns: Enhanced returns relative to appropriate benchmarks can be delivered in the form of income and/or capital growth.

• Reducing risk through diversification: Exposure to different asset classes, investment strategies and markets reduces the risk of having too much exposure to one asset class.

• Easy access to alternative assets and markets: Offer exposure to various global markets and assets such as global equity, commodities and FX. • Global market exposure with or without the FX risk:

• Absa offers a range of structured solutions, with either defensive (conservative) or moderate (equity alternative) risk profiles. For more information, visit ss.absa.co.za