Risk perceptions and structured products

Structured products offer a balance of risk and reward. In particular, products that offer “100% capital protection” can look attractive in times of uncertainty or for particularly risk averse investors.

Marc Chamberlain, vice president of equity distribution, UK team, Morgan Stanley.

Different structured products achieve this capital protection in different ways. Until recently, these differences have figured only in the “small print” – most investors have been confident that their money is safe and not needed to know the details. However, the recent turmoil in financial markets has brought this issue to the fore: there is a realisation that financial institutions can collapse. Depending on how the product is constructed, this can impact investors’ returns.

Before investing, investors have a greater need to understand not just that their capital is protected, but how it is protected. As long as investors appreciate the risks and can make a clear comparison with other investments (for example, corporate bonds, investment funds, cash deposits or direct equity investment), these products can form an important part of an investment portfolio.

Protecting capital

Most capital protected products work in the same way. The issuer uses the proceeds from subscriptions to do two things: 1) buy a derivative contract to give a growth or income return, and 2) buy assets to secure the capital. These assets can include equities, corporate bonds or bonds issued by banks, supranationals and governments. In each case, the capital protection provided by the structured product depends on these underlying assets. Investors should be comfortable that the issuers of these assets (for example, the UK government in the case of a product backed by UK gilts) are not going to default on their obligations.

Credit ratings of issuers can be a useful way of comparing the different assets that can be used to back structured products. However, no investment is totally free from credit risk: what is important is achieving the right balance of risk and reward for the investor.

Balancing risk and reward

Protecting capital by buying the highest quality bonds (for example, G7 government bonds) is more expensive than buying bonds that are perceived to be lower quality. As a result, the terms available on the structured product backed by G7 government bonds will be less attractive than terms on a product backed by lesser quality bonds, as the issuer has less to spend on the derivative contract. Investors might receive a lower participation rate in any upside, or their potential growth or income might be capped at a certain level.

Investors need to choose the balance of risk and reward that is right for them: accepting more credit risk to enhance returns, or minimising credit risk and limiting potential returns. For example, if an investor is prepared to accept a product backed by an A+ rated financial institution, terms are likely to be significantly better than for an equivalent product backed by UK gilts.

Providers understand that the confidence of many investors has been tested by recent market volatility, and are introducing alternative lower-risk solutions into the market, alongside their more traditional offerings.

For example, products where protection is provided by G7 government bonds can help mitigate the credit risk of the investment, but investors need to be aware that they will detract from the returns they can achieve. There is now more choice for investors than ever.

Before investing, however, it is especially important for investors to check the small print – to make sure they get the best product for the amount of risk they are prepared to take. Finding the right balance of risk and reward for an individual’s investment portfolio, and the right structured product that will help achieve the portfolio’s investment goal, could make all the difference.

Marc Chamberlain is vice president of equity distribution, UK team, at Morgan Stanley. The opinions expressed are his own and do not necessarily reflect those of his company. No recommendations are implied by publication of this text.