Adam Cowperthwaite of Daiwa Capital Markets explains the key features of capital guaranteed products, in particular the risks and issues for investors to consider – both when buying and selling them.
Date: June 2010
Tags: Capital guarantee, Maturity, Issuer, Credit risk, Leverage, Fees
Capital guaranteed products are investment products designed to return to the investor, at a minimum, their initial investment notional at the maturity date – or depending on the terms of the product, possibly at an earlier date – plus some kind of investment return, said Adam Cowperthwaite in an interview. That return could be yield or growth.
Typically, these are hold-to-maturity products, and investors should view them this way, he said.
The main risks
According to Cowperthwaite, the primary risk with capital guaranteed products relates to who the issuer is.
As the financial crisis showed, not all issuers are equal, he explained, so credit risk has come to the fore as a result.
The second risk that Cowperthwaite said investors should consider relates to what their intentions are in buying the product. For instance, do they realistically intend – and can they within their financial circumstances be reasonably sure – to hold the product until maturity?
Given that most capital guaranteed products are intended as buy-and-hold products, Cowperthwaite said the risk in exiting early could be that the product might not have performed in the way investors had expected at the outset.
The performance of an embedded option within a capital guaranteed product will not necessarily be in line with the market mid-term, he explained, meaning investors might not be able to apply the payout profile to the current market performance half-way through the life of a capital guaranteed product, and then receive that performance if they unwind early.
Numerous factors affect the pricing and performance of the embedded equity derivative, as well as of the zero-coupon bond part of the structure – assuming it is this type of capital guaranteed product.
Performance below expectations
For example, said Cowperthwaite, an investor might buy a capital guaranteed product today, at current market rates, linked to a basket of indices, with a five-year maturity, but then only hold the product for two-and-a-half years. At that point, interest rates might have risen, markets might have performed well, and the investor asks for a price.
The price is calculated as the present value of the capital guaranteed portion plus the value of the option, he said.
Yet the present value of the capital guaranteed portion will have been affected by the rise in interest rates, so might have fallen below the present value on the start date. And the value of the option, despite markets having performed well, might not necessarily have risen – and certainly not in line with the performance of the underlying indices.
This is because of numerous market factors, explained Cowperthwaite, such as volatility, falling time to maturity, and correlations between the markets.
The investor might therefore find that the valuation of the capital guaranteed product at the point they want to sell it might not match with their expectations give the market performance, he said.
That was frequently the case just before the financial crisis, he added, when investors were looking for valuations in capital guaranteed products and couldn’t understand why they hadn’t risen 50% in value, for example, to match the increases in the underlying indices.
Product fees
When it comes to fees, Cowperthwaite said these are a necessary part of any structured product, in the same way as they are a necessary part of any managed investment. Those people involved in building and managing structured products need to pay various fixed costs and make the business worthwhile, he explained.
At the same time, he said it has been interesting to see the positive industry development of fees becoming more transparent, and of overall fee levels coming down for the same types of structured products.
As a result, Cowperthwaite said investors should be seeing more value being put into the structured products they are buying.
