Such volatility is nothing new: we have seen similar instances of such market behaviour over the last couple of years as tentative recoveries were quickly halted by a resurgence in macro concerns.
This continued uncertainty, coupled with investor demand for safety, has led structured product providers to launch a new breed of defensive products.
While historically, defensive features have largely sought to increase the level of protection on offer, this new breed of defensiveness focuses on the return element of a product.
Examples of two popular payoffs that now feature the potential for returns in falling markets are defensive autocallables and defensive digitals.
Defensive autocallables
The popularity of autocallables, or "kick out/bonus" plans in the UK retail market continues to rise. This is largely due to their ability to offer attractive fixed returns even when markets are stable or moderately positive. Recent months have seen providers introduce a defensive element to this popular structure.
Instead of offering investors the chance to kick out if the underlying asset is at or above 100 per cent of its initial level, some autocallables can now kick out at lower levels, for example at 95 per cent or 90 per cent of the initial level.
In some cases, providers have created products where the kick-out barrier decreases over the term. For example, the kick-out barrier may be set at 100 per cent after the first year, and then decrease in steps of 5 per cent at the end of each further year.
As with any investment product, if risk is reduced so is the reward potential, and the fixed returns available on these products decrease as the kick-out barrier is reduced. Nevertheless, these products offer an interesting risk/reward alternative. To find out how effective this can be, we ran an analysis looking at how often and at what point, various kick-out barriers would have been triggered for a classic six-year kick-out product:
Historical analysis of kick-out barriers, based on rolling 6-yr maturity dates*
| Kicked out in / barrier |
100% |
95% |
90% |
| Year 1 |
76.62% |
81.68% |
86.64% |
| Year 2 |
9.1% |
7.2% |
4.59% |
| Year 3 |
1.37% |
1.54% |
2.94% |
| Year 4 |
3.83% |
3.14% |
1.22% |
| Year 5 |
1.7% |
1.58% |
1.72% |
| Year 6 |
1.4% |
1.92% |
2.11% |
| No kick out |
5.98% |
2.94% |
0.76% |
Source: Morgan Stanley
Unsurprisingly, the majority of autocallables would have historically kicked out after the first year, but this is not necessarily to the detriment of the investor as these products would have returned investors’ initial capital with a fixed return after only one year.
Further analysis shows that reducing the kick-out barrier by 5 per cent increased the proportion of occasions that a product would have kicked out after only one year by approximately 5 per cent as well.
The striking feature of this analysis is the impact of a reduction in the kick-out barrier on whether the product would kick out at all.
Given a kick-out barrier of 100 per cent, 6 per cent of products would not have kicked out, leaving investors either with no return over a 6-year term, or a potential capital loss.
By reducing the kick-out barrier to 90 per cent, this scenario was almost completely removed – only in 0.76 per cent of the back-tested observations would investors not have received a return at all.
Defensive digital products
A distant cousin of kick-out products, the digital also continues to strike a chord with investors during these uncertain times. Like autocallables, they offer investors a fixed return provided that the underlying index is at or above a certain barrier.
The main difference is that these products usually do not feature multiple observations: instead, this barrier is only observed at maturity, effectively making these products an all-or-nothing investment.
With this in mind, it makes sense that some providers have moved towards lower digital barriers as this increases the chance of an "all", rather than a "nothing" return.
For example, backtesting a six-year digital to the inception of the FTSE shows that a digital barrier at 100 per cent would have produced returns in almost 80 per cent of the cases. However, when this barrier was reduced to 80 per cent, the historical chance for a payout increased to almost 96 per cent.
However, a new breed of defensive digital products is emerging. Instead of exposing investors to an all-or-nothing choice, this type of product pays out a fixed maximum return if the underlying closes at or above a defensive barrier at maturity, but still offers positive, albeit lower, returns if the underlying closes below this barrier.
The following diagram compares the two types of payoffs (both with a 50 per cent capital-at-risk barrier observed at maturity only), which, subject to the pricing environment, can offer quite similar returns.
Source: Morgan Stanley
Source: Morgan Stanley
Ultimately, an investor considering a defensive product must make the decision to invest based on his or her own risk appetite and market view.
Some investors feel that the increased chance of receiving a return sufficiently compensates them for a lower defined return. Others may think that a kick out or digital barrier at 100 per cent is sufficiently conservative. In either case, these defensive products represent a healthy addition to the UK retail structured products market and an increased range of choices ultimately benefits both investors and advisers.
Neville Godley is vice-president of Morgan Stanley's retail structured products distribution team. The views expressed here are his own.
*Since the inception of the FTSE 100 index on 4th January 1984.