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2008 FIRMA National Conference

2008 FIRMA National Conference. Why You Should Know About Structured Products. By : Eric Miller Managing Director. Date: April 7, 2008. Contents. What Are Structured Products? Industry Trends Current Market for Structured Products Looking Ahead: Emerging Themes for 2008

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2008 FIRMA National Conference

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  1. 2008 FIRMA National Conference Why You Should Know About Structured Products By : Eric Miller Managing Director Date: April 7, 2008

  2. Contents What Are Structured Products? Industry Trends Current Market for Structured Products Looking Ahead: Emerging Themes for 2008 Challenges & Opportunities Section 1 Section 2 Section 3 Section 4 Section 5

  3. What Are Structured Products?

  4. Structured Products Overview Tools for Shaping Client Portfolios • What Are Structured Investment Products? • Structured investment products are investment vehicles which allow investors convenient and tailored exposure to a specified reference asset. • Both upside and downside exposure to the reference asset can be modified to suit investors’ investment preferences. • About half of all structured products issued in the U.S. provide full downside protection for the invested amount, but partially protected and unprotected structures are gaining popularity. • Most structured products can be cleared and settled via DTC or Euroclear. • Properly applied, structured products can be used to: • Selectively take on desired risk exposures while shedding undesired risks • Customize investments according to specific market views • Conveniently gain access to alternative investment classes that may be difficult to invest in directly • Eliminate or hedge specific portfolio risks or business risks • Currency risk of foreign investment assets • Inflation linked notes to hedge rising cost of liabilities for defined benefit pension plans

  5. Structured Products Overview Reference Assets – Many Choices The return on a structured product investment can be linked to any major asset class. In addition to the most popular asset classes listed below, credit-linked and emerging market-linked products are gaining interest among more sophisticated investors.

  6. Alternatives to Traditional Asset Allocation Cash Alternatives • Short-term maturities (1 year or less) • principal protection • Potential to exceed traditional money market investment returns Bond Alternatives • Principal protection • Potential to exceed current fixed income yields Equity Alternatives • Structured equity solutions may be customized to meet the specific market views and risk tolerance of investors • Potential to exceed equity market returns Return EquityAlternative BondAlternative Cash Alternative Risk / Volatility Re-allocation example A principal protected equity linked note reduces the investment risk by incorporating principal protection, thus redefining the asset as a fixed-income alternative. By obtaining direct equity exposure in this manner it improves the risk adjusted performance of the overall portfolio. Structured Products Overview

  7. Structured Products Overview What are the building blocks of Structured Products? • The pricing components of an Index-linked Principal Protected Structured CD are: • A zero coupon bond • An equity or index option Principal Protected Structured Product Zero Coupon Bond Option

  8. Structured Products Overview What are the building blocks of Structured Products? Assume $100 is invested in a 5 year Principal Protected Structured Note, a 5-year interest rate of 5% and a face (or par) value of $100.The current value of the zero coupon bond is $75. The zero coupon bond will accrete to a value of $100 in 5 year and guarantee the full repayment of principal. Thus, $75 is the current cost of providing the principal protection.Difference of the $100 invested in the Structured Note and the $75 set aside for principal protection is $25. HSBC allocates $24 to an option linked to the underlying asset to provide the potential for an index linked return and if applicable, a minimum guaranteed return at maturity. The remaining $1 is paid to Dealer. Investor’s return is based on the initial $100 investment, not $99. $100 = $75 + $24 + $1

  9. Industry Trends

  10. Structured Products Issuance – US The SPA reported a 78% increase in US structured product issuance between 2006 & 2007 US Structured Products Volume – SPA Data Source: Structured Products Association

  11. Structured Products Issuance – North America Registered and unregistered notes, CDs and GICs (excludes EIAs) US/Canada Structured Products Volume – Arete Data Source: Arete Consulting *Canada issuance volumes converted to USD using respective end-year USD-CAD cross-rates

  12. Structured Products Issuance – Industry Comparison Structured products issuance is now on par with other forms of retail investment product 2007 New US Issuance Volume Sources: Arete Consulting, ICI (Investment Company Institute), First Trust Portfolios LP

  13. Industry Trends - Wrappers The trend toward unlisted registered notes continues CD issuance gained, despite a bull market in US and international equities US Structured Product Issuance Volume 2005 2007 $19 billion $34 billion Source: Arete Consulting

  14. Market Trends - Underlyings Non-equity products have gained market share Interest rate and FX-linked structures have grown in popularity over the past two years US Structured Product Issuance Volume 2005 2007 Interest rates 89% 80% Source: Arete Consulting

  15. Market Trends – Top Underlyings US single index underlyings are consistently popular, but a trend towards FX, commodities and global index baskets is also evident US Structured Products Issuance Source: Arete Consulting

  16. Market Trends – Principal Protection Significant growth in reverse convertible volumes and a bull market in US equities have driven down the market share of principal protected structures Distribution of US Deals by Capital Protection Level Source: Arete Consulting

  17. Current Market for Structured Products

  18. Current Market for Structured Products • Credit Crisis Challenges Investor Confidence • Investors initially enjoyed better structured product terms due to issuer funding difficulties (Merrill Lynch, Lehman, Bear Stearns) • Then, the unthinkable almost occurs: could one of the largest US commercial or investment banks fail? • Bear Stearns bailed out by the Fed, JPM • Structured product investors now increasingly choosy about issuer credit quality What a difference a year makes Source: Bloomberg NB: CDS spreads and USD share prices from 15 March 07 and 17 March 08

  19. Stock Market Volatility Up VIX Index – 5 Years, Weekly Data Stock Market Performance Down S&P 500 – 1 Year, Daily Data Current Market for Structured Products Investors are uncertain as to the direction of the stock market in the short to intermediate term. Source: Bloomberg

  20. Current Market for Structured Products • Reverse Convertibles Perform Poorly • More reverse convertibles are returning stock • Sales volumes begin to plateau in 2nd half of 2007 • Apple Inc. falls 40% from peak to trough in past 3 months Apple Inc. – 6 Months, Daily Stock Price Even Apple Inc. stock takes a dive Source: Bloomberg

  21. Current Market for Structured Products • Searching for Safety • Increased demand for principal protection especially via CDs as FDIC insurance comforts credit fears • Partial protection OK as long as protection is “firm”, not “contingent” • Performance Through Uncertain or “Sideways” Equity Markets • Absolute return notes for equity cash on the sidelines • Accelerated return notes: more bang for the buck • Quest for Yield Continues • Autocallable notes gaining popularity beyond Latam and Private Banking marketplace • Return of the LIBOR range accrual note Brokers and advisors are looking beyond Reverse Convertibles

  22. Looking Ahead: Emerging Themes for 2008

  23. Emerging Themes for 2008 - Convergence • New Wrappers for Structured Investments • Mutual funds and Unit Investment Trusts (UITs) offering principal protection • Closed-end funds offering buy/write yield enhancement strategies • Active Management Offered via ETFs • Recent regulatory approval for the first actively-managed ETFs • Formerly the territory of mutual funds and SMAs • New “Strategy-based” Indices • Replicating active management techniques for structured notes • S&P’s DTI and CTI indices (HSBC) • SEVENS Index (UBS, MS) • Citibank Country Selection Index (Citi) • Adagio Index (Bear Stearns) The asset management industry continues to evolve

  24. Emerging Themes for 2008 – Access via Structured Products • Market Volatility Encourages Search for Uncorrelated Investments • Hedge funds still inaccessible to many retail investors • Advisors more willing to consider other (non-equity) asset classes • Investors Round Out Equity Portfolios • Emerging markets: have these economies de-coupled from G7? • Access to “Frontier” markets • Customized Indices Provide Access to Sectors & Themes • Increasing development of new indices by Issuers in conjunction with S&P and Dow Jones • Daily pricing via Bloomberg/Reuters and independent calculation agent instill investor confidence As interest rates fall and the bull market in equities fades, investors look elsewhere for returns – often in hard-to-access investment areas Source: Prospect News NB: YTD data through March 24 of each year

  25. Challenges & Opportunities

  26. Today’s Challenges... • Credit Crisis • Avoid the taint of problems in the structured credit market (SIVs, CDOs, etc) • Restore confidence in the credit-worthiness of Issuers • Taxation of ETNs • Aggressive marketing of ETNs has led to increased scrutiny • Clearer guidance as to tax treatment of certain structured products may benefit industry • Poor Performance of Reverse Convertibles • Independent broker-dealer channel most vulnerable • Current Market Environment Unfriendly for New Equity-linked PPNs • Low interest rates, high equity volatility • Opportunity for more interest-rate and FX linked principal protected notes/CDs Today’s challenges will lead to new opportunities and encourage continued innovation

  27. ...and Tomorrow’s Opportunities • Get the Word Out! • Increased broker awareness of structured products through education • Nearly ¾ of structured product volume in 2007 sold via Issuers with internal distribution channels1 • Great Time for Structured Products to Shine • The current market environment highlights the many benefits of structured products: • Attractive combinations of risk and reward • Access to uncorrelated asset classes and hard-to-reach markets • Returns linked to customized and/or strategy-based indices Today’s challenges will lead to new opportunities and encourage continued innovation 1Source: Structured Products Association

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