A Guide To Retail Structured Products Lowes Financial management
Lowes Financial Management is an Independent Financial Adviser with a forty-six-year pedigree. We have been active reviewers of the structured product market and have used them within client portfolios since the early 1990s. We were one of the country s first firms to achieve the accreditation Chartered Financial Planners and we advise across a wide range of investments taking an holistic view of clients requirements of which structured products are just one element. When structured products began appearing in the UK retail investment market the number of contracts available was initially very small but by 2000 they were being released at the rate of three or four a month. As the supply of contracts increased, we began to identify an alarming number that we felt were potentially misleading and providing arguably insufficient reward in return for the risk to which the capital was being exposed. As a result, we launched an online review service and published a leaflet entitled The Truth Behind Those High Yield Stockmarket Bonds. The first article warning of the dangers of what later became known as precipice bonds was published in October 2000 and was as a direct result of the Lowes leaflet. Our original review service helped many Independent Financial Advisers and investors navigate the market and has evolved to become a comparison and educational service now used by thousands of advisers across the country. Lowes frequently contributes to the media and we are often the first point of contact for the press looking for unbiased and objective comment on all matters in the financial services industry, particularly relating to structured products. Ian H Lowes Managing Director of Lowes Financial Management
Contents Introduction 4 Structured Deposits 5 Structured Capital protected Products 6 Structured Capital-at-risk Products 6 Maturity Performance 7 Product Types 8 Growth 8 Income 10 Auto-call / Kick-Out 12 Capital Protection Barriers 14 Tax Treatment 17 Plan Manager / Deposit Taker / Counterparty / Issuer 18 Collateralisation 20 Ways to Invest 21 3
Introduction We define a structured product as, An investment backed by a significant counterparty (or counterparties) where the returns are defined by reference to a defined underlying measurement (such as the FTSE 100) and delivered at a defined date (or dates). There are many variations but a capital-at-risk structured product might for example offer a return of 50% on the investment if the FTSE 100 is at the same level or higher on the day the product matures in 6 years time. If the FTSE 100 is below that level, it will return the original investment amount, unless it is more than a specified amount below, say 50%, whereupon capital would be reduced by the equivalent fall in the FTSE 100. We have been using such investments in our client portfolios (and our own) since the early nineties and while past performance is not a reliable indicator of future performance, they have helped to enhance portfolio returns while at the same time providing protection against stockmarket falls. We believe that structured products offer many attractive features which can be used to satisfy a variety of investor needs. However, we do not believe they should be seen as a replacement but as a complement to traditional investments such as funds. One of the possible outcomes of structured investments is that they simply return the original capital at maturity. This inherent capital preservation feature would be welcome in adverse market conditions. However, the effects of inflation potentially eroding the real value of the invested capital should not be overlooked. Most structured products may be sold during the term but they are designed to be held until their maturity. If sold early, the investor may get back less than they invested, even if the underlying asset has performed well. These investments should therefore only be considered if the intention is to hold them for the full investment term. 4
In extreme circumstances such as a bank failure some of these investments could result in the investor losing some or all of the money they invest. It is essential that, as with any investment, the product literature and terms and conditions are carefully considered to ensure that the investor understands the risks involved before investing. There are two main types of structured products; structured deposits, structured capital -at-risk products (the latter are also referred to as structured investments). Structured Deposits As the name suggests, structured deposits are essentially fixed-term deposit accounts where, instead of interest being earned at a set or variable rate, the return is fixed but depends on the performance of the underlying asset, such as the FTSE 100. So, for example, a deposit plan might offer 15% return on the capital after 4 years as long as at the end of the investment term, the FTSE 100 is at or above the level at which the investment started. While nothing is completely risk free, structured deposits are designed to return investors original capital as a minimum at maturity. As with most UK deposit accounts, structured deposits usually include the potential benefit of protection should the deposit taker become insolvent during the investment term. This protection is provided by the Financial Services Compensation Scheme (FSCS) and UK eligible claimants have a right to claim up to 85,000 per individual per institution in such circumstances. The availability of such compensation is, however, dependent upon the investor s eligibility as defined under the terms of the FSCS. 5
Structured Capital-at-Risk Products Structured capital-at-risk products have defined risk and reward features. This means that as well as some of the reward of potential returns, there is the risk that the capital invested can be lost in adverse market conditions. As with other structured products there are pre-defined outcomes depending on how the underlying asset has performed at the end of the investment term. These investments, because they include risk of loss of capital due to market movements will, offer a potentially higher return than structured deposits, which offer greater protection of the investment capital. The investor is potentially being paid a premium for taking the greater risk. Nevertheless, many capital-at-risk products will protect capital unless there is a large fall in the markets. For example, some products will only reduce the capital returned at maturity if the FTSE 100 has fallen by more than 50%. Capital return is, therefore, dependent upon movement in the underlying asset and the extent of any protection barrier. Also, rather than being deposits, structured capital-at-risk products most often take the form of loans to banks or other financial institutions. The returns outlined for any structured capital-at-risk plan, including the return of capital, are therefore dependent upon the issuing institution remaining financially solvent for the full product term. They do not have the benefit of the Financial Services Compensation Scheme in the event of the insolvency of the issuing institution. Structured Capital Protected Products Structured capital protected products are no longer utilised within the UK retail sector, the last issue of such a product was in 2014. These products were designed to return the original capital as a minimum. However, like structured capital-at-risk products, they were structured as loans to a counterparty bank rather than being deposits with a bank. The returns outlined for any structured capital protected product, including the return of capital, were therefore dependent upon the counterparty bank, remaining financially solvent for the full product term. 6
Maturity Performance Lowes Financial Management maintains what we believe to be the most extensive database of structured products available from any source in the UK as a function of our analysis of the sector. This database covers almost every product launched in the UK IFA distributed space since 2000. We record maturity results of all products and issue regular maturity performance analysis. Whilst past performance is not a guide to the future, the following table shows how each product category performed during a period of 1 and 5 years to 30/06/2017. Since the early days of the sector, Lowes have stated at the time of each products launch which ones are Preferred by the company and as such, might be utilised in our day to day role of advising clients. The performance of the Preferred products are shown separately. Structured Deposits 1 year to 30/06/2017 Capital Protected Capital at Risk Preferred by Lowes Analysis and Annualised Performance by Product Type Structured Deposits 5 Years to 30/06/2017 Capital Protected Capital at Risk Preferred by Lowes 93 31 501 165 Number of products maturing 79 21 484 165 Number that generated positive returns 14 10 6 0 Number that returned capital only 0 0 11 0 Number that lost capital 5.15 yrs 5.72 yrs 3.35 yrs 3.42 yrs 3.45% 2.17% 7.50% 8.63% 6.09% 5.05% 11.06% 11.52% 0.48% 0.00% 3.80% 5.90% Average duration / Term in years Average Annualised Return Top 25% Avg. Annualised Returns Worst 25% Avg. Annualised Returns 458 361 1533 581 399 275 1449 517 59 86 34 40 0 0 50 24 4.51 yrs 5.31 yrs 3.21 yrs 3.50 yrs 4.16% 3.94% 7.89% 7.44% 6.83% 8.02% 12.26% 11.96% 0.82% 0.00% 3.39% 1.72% 7
Product Types There are several types of structured product, which may prove suitable for different investment requirements. Growth An investment designed to provide growth, which can be a fixed return dependent on underlying asset performance over the investment term, or geared participation in the same performance. Geared participation means that an investor potentially receives a gain equal to a multiple of any rise in the underlying measurement. Participation rates for products linked to the FTSE 100 have, for example, varied between 1 times any rise (more likely to be seen on structured deposits) up to over ten times any rise. Participation in an index is often capped at a maximum return on the original capital and some plans have also offered a minimum return. For example, a plan may offer 10 times any rise in the FTSE 100 over 6 years, capped at 70% maximum gain. If the FTSE 100 rises by 5%, an investor would receive 50% growth, in addition to their invested capital. If the FTSE 100 rose by 7% or more, the investor would receive the maximum 70% growth in addition to their original capital. Please note that most structured products do not include any explicit return for reinvestment of dividend income that would arise if the investment was made directly in the underlying shares in an equity or other yield bearing index. The anticipated benefit of any such dividends however incorporated into the terms of the investments. 8
Example of a FTSE 100 linked capital-at-risk digital growth plan with a 60% End of Term Only barrier. Event Outcome Counterparty default = Return of any capital subject to insolvency proceedings - potential total loss if not If at the end of the term the Index closes at or above its initial level = Return of capital plus a gain of 55% if not If at the end of the term the Index is lower but by no more than 40% = Return of capital only if not As the index is more than 40% lower = Capital is reduced in line with the fall in the Index on a 1% for 1% basis This is an Example only - It is important that you are aware and understand all risks associated with a particular plan prior to investing. These risks will be outlined in the product literature. 9
Income An investment typically designed to provide income, payable monthly, quarterly or annually. Some plans pay income gross, so please ensure you are aware of the tax implications of any plan that you invest in (see page 17 for more information on the tax treatment of structured products). Income can be unconditional (payable irrespective of how the underlying assets perform), or conditional. A conditional income payment means that the investor would only receive income if the underlying asset meets certain criteria, such as staying above or below a certain level. If these criteria are broken, some or all of the future income payments could be lost dependent on future performance of the underlying asset. 10
Example of a FTSE 100 linked capital-at-risk unconditional income plan with a 50% Full Term Daily Close barrier. Event Outcome Counterparty default = Return of any capital subject to insolvency proceedings - potential total loss if not If the Index did not fall by more than 50% during the term or the Final Index Level is above the Initial Index Level if not As the Index fell by more than 50% during the term and the Final Index Level is below the Initial Index Level = = Return of invested capital plus a gross quarterly income of 1.3% paid throughout term Capital is reduced in line with the fall in the Index at maturity on a 1% for 1% basis. Income received during the term unaffected This is an Example only - It is important that you are aware and understand all risks associated with a particular plan prior to investing. These risks will be outlined in the product literature. 11
Auto-Call / Kick-Out An investment that may have a maximum term of, say, six years but has the potential to come to an end and pay out a set amount on specific anniversary dates, depending on the terms of the product. The most common example of this would be if the underlying asset (for example the FTSE 100) is at or above its initial level two years after the start date, the plan would mature, returning investors original capital in full and the set payment for two years. If these criteria are not met, the plan continues until the next anniversary date and the same criteria are checked. This continues until either the plan kicks-out or it reaches the end of the investment term. For example, a product might have a 6-year term and offer a gain of 8% for each year held and will mature on any anniversary from the second year onwards if the FTSE 100 is at or above the index level recorded at the start level of the investment. So, if the FTSE 100 level at the start of the investment term was 7000 if on the second anniversary the level is at or above 7000, the product comes to an end giving the investor a 16% return. If the FTSE 100 is below 7000 at that point, the investment continues and at the third anniversary, if the FTSE 100 is at or above 7000 the investment matures giving the investor a 24% return. This continues each year, adding 8% per year until the end of the six years. At that point if the FTSE 100 is at or above 7000 the investor receives a 48% gain on their original capital, being 6 times 8%. These plans are often capital-at-risk products which means they protect capital from losses due to falls in the underlying asset only to a certain point. In the example above, the plan might protect capital, i.e. will return it in full, unless the FTSE 100 is lower on every anniversary and is 40% below the 7000 starting level on the final anniversary i.e. below 4200. If it is below that level, then like many other investments that do not protect capital at all, the investor will lose money this is usually at a 1% loss of capital for every 1% the FTSE 100 is below the start level. 12
Example of a FTSE 100 linked, capital-at-risk, auto-call / kick-out plan with a 60% End of Term Only barrier Event Outcome Counterparty default = Return of any capital subject to insolvency proceedings - potential total loss if not If on any annual observation date the Index closes at or above its initial level if not = Return of capital plus a 8% gain for each year the plan has been in force If at the end of the term the Index is lower but by no more than 40% = Return of capital only if not As the Index is more than 40% lower = Capital is reduced in line with the fall in the Index on a 1% for 1% basis This is an Example only - It is important that you are aware and understand all risks associated with a particular plan prior to investing. These risks will be outlined in the product literature. 13
Capital Protection Barriers One of the major benefits of structured products can be the degree of protection to capital that they can provide during adverse market conditions. Structured deposits and capital protected plans offer a return of the original investment in full regardless of market conditions unless, in the case of the latter, the issuing institution fails or defaults. Most capital-at-risk products offer some protection to capital against all but the most extreme market conditions. However, all protection is subject to the ongoing solvency of the issuing institution. There are two main barrier types that apply to capital-at-risk products: End of Term Only These plans aim to return the original investment at maturity, provided that the final level of the underlying measurement is not below the initial level by more than the specified percentage known as the barrier level. For example: a 60% End of Term Only Barrier will return the investor s capital in full at maturity as long as the final level taken at the end of the investment term is no more than 40% below the initial level. If it is below that level then capital will be reduced, in the vast majority of instances, directly in line with the fall in the underlying asset. The barrier is only observed at maturity. These barriers are technically referred to as European barriers. Full Term Daily Close Some plans feature barriers which are observed on the closing daily level of the underlying asset for the full term rather than only at the end. If the barrier is breached a loss will occur at maturity if the underlying asset / index value has not recovered sufficiently. Products with such barriers are more risky than those with End of Term barriers. These barriers are technically referred to as American Barriers. 14
How do European (End of Term) and American (Full Term) barriers work? The hypothetical product strikes at an index level of 7000, matures at an index level of 4970 (29% Lower). The 50% American barrier would be breached, if at any point during the investment, the index level fell below 3500 points. Investors would suffer a loss to capital if the index did not recover to at least the Initial Index Level. Alternatively, the European barrier is monitored at end of term only, therefore in order for the barrier to be breached, the Final Index Level would have to be below 4200. 8000 Strike Level 7000 Index 50% American Barrier 60% European Barrier 7000 Final Index Level 4970 6000 5000 4000 European barrier assessed at the end of the product term. Return 100% 3000 2000 Barrier Breached at Index Level 3500 3421 American barrier assessed daily through the term of the plan. Return 71% Lowest Index point during the term of the plan 15
Dual or Multi Index and Share-Linked Products While many of the structured products in the market use the FTSE 100 as the index against which they benchmark to derive their returns (the defined underlying measurement), there are some that link the returns to more than one index. Dual index structured products will typically offer a higher potential return than those based on a single index because the risk of achieving no return, the risk of a loss arising and, or, the extent of any loss is dictated by the worst performing index. The higher potential return is therefore in keeping with the relatively higher risk, when compared with a structured product based on a single index. The most common pairing of indices is the FTSE 100 and the Eurostoxx50. These indices include the blue chip companies in the UK and the Eurozone and are usually paired because they have a relatively close correlation, thereby increasing the probability that they will move in the same way in given market conditions. It is possible to pair any set of indices (or to use three or more indices in a product) as well as to design products that use the listed price of individual stocks as the defined underlying measurement. Products can, for example, use groups of five or ten of the major stocks in the FTSE 100 as the benchmark that determine the returns. Share-linked structured products utilise a basket of individual shares as the underlying measurement. These plans generally pose a greater risk to investors capital than for example, FTSE-only linked plans as the worst performing share often dictates the extent of any loss or gain. The increased risk, however, often means an enhanced potential coupon in return. 16
Tax Treatment If a structured product is held directly, i.e. outside a tax shelter such as an ISA or a SIPP (Pension), it will usually be subject to tax. Most non deposit based growth plans are designed such that a UK retail investor will incur a potential Capital Gains Tax liability at maturity. However, with proper planning, this can be used advantageously, as every individual has an annual capital gains exemption ( 11,300 for the 2017/18 tax year). Any losses can usually be able to be netted against gains for the tax year in which they fall. Any gains that fall outside the annual exemption in the year of maturity will be subject to tax at the prevailing rate, which for the 2017/2018 tax year is 10% for basic rate taxpayers and 20% for higher rate taxpayers. Income plan payments will usually be subject to UK Income Tax at the investor s highest marginal rate via self assessment, which should be declared to HMRC. Deposit based plans are also subject to income tax at the investors highest marginal rate via self assessment which should be declared to HMRC. Interest may be paid gross or with basic rate tax deducted at the discretion of the plan provider. 17
Plan Managers Many structured products will have a Plan manager. This company will be a Financial Conduct Authority regulated firm responsible for a variety of duties including the design, packaging and distribution of the products. All post-sale communications will be issued by an administrator appointed by the Plan Manager. It is important to understand that the Plan Manager of your product may not necessarily be linked in any way with the organisation providing the assets which underpin the product itself other than facilitating the contract. Deposit Taker All structured deposits have a deposit taker which will hold the deposit. The return of capital will be dependent upon the continued solvency of the deposit taker throughout the term of the investment. in the case of the deposit taker becoming insolvent, eligible claimants in a structured deposit may have a right to claim up to 85,000 per investor, per institution from the Financial Services compensation Scheme (FSCS). Counterparty / Issuer As we have already identified, most structured investment products will be structured as a loan to a major financial institution. Like any loan, there is a risk that the borrower may not be able to meet its financial obligations and fall into insolvency. Investors must be aware that unlike deposit based products, structured investment plans do not benefit from FSCS cover if the issuing financial institution goes bankrupt. It is of paramount importance, therefore, that investors understand the risks of placing their money with the issuing institution. Credit ratings provide the most recognised barometer for assessing institutional creditworthiness. Standard & Poor s long-term credit ratings range from D to AAA where, for example, CC indicates that the financial institution is currently highly vulnerable in terms of its financial commitments, and AAA denotes that the financial institution has extremely strong capacity to meet its financial commitments. These ratings may be modified by the addition of a + or - sign to show relative standing within the major rating categories. 18
Similarly, Moody s long-term credit ratings range from C to Aaa where, for example, Baa infers that the financial institution s obligations are judged to be subject to moderate credit risk, are considered medium grade and may have speculative features, and Aaa which infers that the financial institution s obligations are judged to be of the highest quality, with minimal credit risk. Moody s ratings also include numerical modifiers 1, 2 and 3, where 1 indicates the higher end of its generic rating category and 3 indicates the lower end. Credit ratings are the most common form of credit assessment and are used by investors of all levels of financial sophistication. However, it is important to realise that they are not completely infallible. No matter how unlikely the collapse of a major counterparty may seem, it is not impossible and we do not believe that any bank could survive a run without external support. Investors should therefore consider the implications that the resulting loss would have for them should the counterparty fail and their portfolios should be diversified appropriately. Long-term Ratings Standard & Poor s Moody s AAA Aaa AA+, AA, AA- Aa1, Aa2, Aa3 A+, A, A- A1, A2, A3 BBB+, BBB, BBB- Baa1, Baa2, Baa3 BB+, BB, BB- Ba1, Ba2, Ba3 B+, B, B- B1, B2, B3 CCC+, CCC, CCC- Caa1, Caa2, Caa3 CC Ca C C RD - D - 19
Collateralisation To mitigate counterparty risk, some plans are collateralised - this is where the money raised by the issuing institution is not held on its own balance sheet but invested into collateral assets. The collateral itself can be varied in nature but is normally made of securities such as government bonds (gilts), cash, equities or loan obligations of other financial institutions. The collateral is held by a separate custodian and the value is normally adjusted daily to match the value of the plan. Some product providers have introduced collateralised plans where the credit risk of the investment is then spread across multiple financial institutions. These plans can mitigate the problem of single issuer risk to the extent that if one financial institution fails only a portion of the investment is likely to give rise to a loss. Whilst diversification of risk is a much vaunted investment principle, it is important to understand that credit risks still remain with these plans and if one of the named financial institutions gets into serious difficultly (a Credit event) that portion of the invested capital could be lost. In the event of an issuing institution of a collateralised product becoming insolvent, an enforced early maturity is likely to occur which could be a lengthy process and result in a return of less than the invested capital. 20
Ways To Invest Investments can be made in several different ways, the most common of which are listed below: Direct Investment A direct investment refers to holding the investment outside of a taxsheltered wrapper such as an ISA or SIPP. Thus, any returns generated by direct investments may be subject to tax as detailed in the plan s individual terms and conditions. ISA Investments held within ISAs (Individual Saving Account) are sheltered from Income Tax and Capital Gains Tax. The annual investment allowance for 2017/18 is 20,000. ISA Transfer Most structured products can accept the transfer of existing ISAs (depending on the product type) from a different provider whilst retaining the tax sheltered status on those funds and without affecting current year ISA subscription allowances. Exit charges may apply from the existing provider. 21
SIPP Many structured investment products can be held in a Self Invested Personal Pension (SIPP) subject to the rules of the pension provider / individual scheme. Wraps / Platforms A number of traditional investment platforms offer access to some structured products. However, the costs are often prohibitive and poor value, particularly as these platforms provide little information about the investment and do little more than facilitate the holding of all of an individual s investments in one place. 22
Please note that structured products may not be suitable for your investment requirements. If you have any doubts as to the suitability of an investment, you do not fully understand the terms or risks or you would like advice, please do not hesitate to contact a Lowes Consultant or this office on 0191 281 8811. This document was produced by Lowes Financial Management. Registered in England No. 1115681. Authorised and Regulated by the Financial Conduct Authority. 23
Fernwood House Clayton Road Newcastle upon Tyne NE2 1TL Tel: 0191 281 8811 enquiry@lowes.co.uk www.lowes.co.uk v09-17