Structured, but not so safe or simple

Structured products held within an individual savings account (Isa) can be attractive to investors who want to blend investment growth with capital protection – but recent history has highlighted the importance of understanding the strength of the counterparties providing capital guarantees, advisers say.

“Structured products can be an investment solution that tackles market volatility, but investors need to understand the risks involved and the features they should be taking into account when considering buying a structured product,” says Paul Inkster of Barclays Stockbrokers.

Capital-protected structured products generally offer a return in line with the rise in a stock-market index, or a defined annual return, provided a specified index does not fall – with original capital returned at maturity as long as the index does not halve.

But this guarantee is reliant on a bank counterparty providing the return of capital, and the collapse of Lehman Brothers – which was the counterparty backing a number of structured products issued by companies such as NDF, Meteor, DRL, Arc and Legal & General – has emphasised the importance of knowing how financially strong the counterparty is.

Jason Walker of AWD Chase de Vere says his firm does recommend structured products but the counterparty has to have a credit rating of at least AA. It currently has two structured products on its panel – both are products from L&G with HSBC as the counterparty.

Some providers are now offering collateralised products in order to remove the counterparty risk, says Clive Moore, managing director of IDAD, a structured product consultancy.

CitiFirst has a G7 collateralised product – backed by government bonds issued by G7 countries – paying 9.25 per cent per annum on the first anniversary that the FTSE 100 is higher than its starting level. This means that were Citibank to go bust, investors in the product would still hold bonds issued by G7 countries which, subject to liquidity in the government debt markets, could be realised quickly.

“The daily liquidity in this is a real boon as well as the security,” explains Moore.

As with most investments, the level of investment risk will affect the returns achievable. Ian Lowes of Lowes Financial Management, the independent financial adviser, says some investors are happy to accept increased counterparty risk in order to boost their potential returns.

In order to qualify as an Isa investment, structured products must have a minimum term of five years and be listed on a recognised stock exchange.

“Investors should bear in mind that this means the products are generally only Isa-eligible in the primary market – when they are initially offered,” says Barclays’ Inkster. “As soon as the term starts, the time to maturity is less than five years, which means Isa investors cannot make a further investment into that particular structured product.”

Lowes says that for a typical investor, an Isa would provide most tax efficiency when holding an income-based plan rather than a growth-based product. Growth-based structured products held outside an Isa will not incur tax if the payout on maturity falls within the investor’s capital gains tax allowance in that year.

But investors must also make sure they fully understand the investment terms. Walker says these can be very complicated for advisers, as well as investors. “It’s best to make sure that things are kept as simple as possible,” he adds.

Many structured products only offer full repayment of capital provided an underlying index has not fallen below a certain level during the term – often referred to as “soft protection”.

“Investors need to think about their view on how that index will perform over the five year period,” says Inkster. “If they feel there is a possibility that the index will breach the lower level, then they need to understand that their initial capital would be at risk.”

For example, the Barclays FTSE 100 Accelerated Returns Note has a five-year term with the FTSE 100 as its underlying index. It offers a return of three times the rise in the FTSE 100 index between the start and the end of the term – subject to a maximum return of 75 per cent – plus the return of the original capital invested. The original capital is returned in full, unless the FTSE 100 index has fallen by more than 50 per cent during the product term and fails to regain its initial starting level. The capital will then be reduced in line with the decrease in the FTSE 100 index.

“As a rule of thumb, the more complicated the payoff is on an investment, the less likely it is to be good value,” says Moore. “Anything with capital return linked to the worst performing stock in a basket of shares, for example, should be considered exceptionally risky.”

Some advisers say they are still unconvinced by the overall value of structured products. Robert Lockie of Bloomsbury Financial Planning says his firm does not recommend them. “Apart from the fact that the value of a guarantee is dependent on the ability of the guarantor to meet it, you are usually foregoing dividends, they are for a fixed-term, they are often hard to exit due to limited liquidity and the price you get will generally be unfavourable,” he says.