Structured products

Structured products are created to provide a return that is linked to, but that that differs, from the returns available fr...

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...products.

This audiovisual presentation provides an overview of some of the key points covered in chapters 2 & 3.

Most structured products are made up of two component parts, the capital guarantee element, and the income or growth-producing element. Structured product providers usually use the majority of an investor’s money to buy a ‘debt’ security or an interest-producing instrument that will provide a fixed return at some point in the future equal to the full amount or a proportion of the money invested. With the guaranteed part secured, the remainder of the premium is used to p...

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...et at a previously agreed price at a specified future date. If, for example, an investor holds a put option on the FTSE 100 index that can be exercised in five years’ time, they will have the right to “sell” the index at today’s price. If the index has dropped, they have protected the value of their investment because they can sell it at today’s price. Again, as an index cannot be “sold”, the settlement is made between the counterparties in cash.

There are many ways of structuring these products to generate different returns – we shall investigate some of the options further in chapter 3. The underlying investment principles however, are relatively straightforward, depending upon whether the product is “growth” or “income” based.

Growth products

A typical growth product could be made up of a combination of debt (using a zero coupon bond) and call options. A sufficient le...

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...er of the option the amount by which the index has fallen (remember index options are settled for cash rather than delivery of underlying asset).

Many income products offer “safety nets” for example, allowing the relevant index to fall by up to 50% (the barrier) before capital is at risk. These offer a genuine reduction in the level of risk of investor capital. They operate by sale of a put option that is only valid if these falls have actually happened.

What underlying assets are tracked by derivatives in struc...

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...cent years, as well as exposure to overseas equity markets.

What are the charges applied to structured products?

The charges that are applied to any contract will have an impact on the total return eventually achieved and can increase or decrease the chances of...

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...ture, it is impossible to know how much of the margin has been taken up with costs, thereby increasing the return required to achieve the targeted returns to provide the guarantees and, therefore, the risk.

What are barriers in relation to structured products?

Barriers are the levels set in the terms of a structured product which dictate the point at which guarantees would be lost. There are two technical types of barrier, ‘European style’ and ‘American style’ and it is important to understand which type of barrier is being used within a structured product as this could have an impact on the probability of the capital guarantee being maintained and, therefore, the level of risk assoc...

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...ume that that a product with an American style barrier is riskier than a similar product with a European style barrier and, therefore, would expect the product with an American style barrier to carry a higher headline rate of return.

The barriers of a product may not be described in these technical terms, so it is important to carefully read and understand the terms and conditions of each product to fully appreciate the level of investment risk associated with it and the suitability for individual clients.

Tax treatment of directly held structured products

The tax treatment of a structured product held directly will depend on whether it is deposit based or investment based.

The returns from deposit based structured products are liable to income tax at the investor’s highest marginal rate of tax and are paid gross. Non-taxpayers have no tax to pay, basic rate taxpayers may have tax to pay at 20% on some or all of the returns depending on the amount received and whether the individual has any available Personal Savings Allowance (PSA), or unused 0% savings rate band. Higher rate taxpayers may have tax to pay at 40% on some or all of the returns depending on the amount received and whether the indiv...

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...eated as having been fully surrendered and chargeable gains calculated in the usual way. Taxpayers may benefit from top slicing relief to reduce the overall amount of tax paid. Higher and additional rate tax payers will pay have further income tax to pay on any chargeable gains.

Member directed pension schemes (SIPP & SSAS)

Structured products can very useful for pension investors, especially those wanting exposure to the market with a limited downside, or where they are looking to produce an income. Structured products can also be useful where the investor wishes to gain exposure to investments which would incur tax penalties should they invest in them directly (e.g. residential property or commodities).

Most structured products are made up of a combination of debt instruments or cash and derivatives

The debt element is often made up of zero coupon bonds. These are loans to the companies that issue them

In r...

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...ther it is deposit based (income tax) or investment based (capital gains tax)

Where a structured product is held within a wrapper, the tax treatment of the wrapper will dictate the tax liability of the investor