Structured products

The risks associated with structured investment products are varied, depending upon the terms being offered. It is, therefore, v...

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... briefly exploring the available tax wrappers within which structured products may be placed, and their advantages and pitfalls.

Structured products generally offer defined returns and/or income in specific investment conditions...

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... can be assessed by looking at credit ratings and the spread on credit default swaps of the issuer.

Credit ratings are issued by three leading ratings agencies, Fitch, Moody’s and Standard & Poors. They can relate to companies, banks, financial institutions and even countries.

Ratings agencies use statistical analysis to rate the financial strength of a financial entity. Each agency uses different methodologies to reach their conclusions, and so the same company or country could have different ratings from different agencies. The three agencies mentioned above all use alphabetical ratings with AAA or equivalent b...

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..., B2, B3

B+, B, B-

CCC+, CCC, CCC-

Caa1, Caa2, Caa3

CCC+, CCC, CCC-

CC

Ca

SD/D

C

C

-

D

-

-

NR

-

-

There are no guarantees behind the ratings, but they provide an indication of the probability (but not the possibility) of a default occurring. An institution with an AA rating is considered less likely to default than an institution with a BBB or equivalent rating.

Standard & Poor’s publish statistics on the corporate defaults for each rating, see sample here (PDF).

Credit default swaps are effectively a form of insurance to protect against the chance of an issuer defaulting on a loan or other financial commitment, and financial institutions buy CDSs to insure themselves against credit default. CDSs are quoted as a...

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...of the market’s expectations and of the creditworthiness of the institutions, whereas credit ratings take a longer term view. Both are useful guides and should be considered in relation to the other information available in relation to the issuer.

What is collateralisation?

This is where real assets are used to underwrite the guarantee provided by a structured product in a similar way to which a property is used as security for a mortgage. The assets are held i...

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...estment?

Is the investors’ capital unaffected if an underlying asset used for collateral defaults during the life of the plan?

What is the mechanism for payment of the collateral and how long will this take?

As we have seen from our earlier studies of structured product types, there are many that do not guarantee the return of the investor’s original capital due to the way in which the product is constructed. Even where some hard protection is offered, there is always the risk that a counterparty involved in the deal will default on its commitment, so a product perceived as 'safe' may still result in the investor’s original capital being at risk. For these reasons, the FCA takes the view that structured investment products are unsuitable for customers who do not want to take any risk with their capital or have no capacity for loss. Furthermore, firms wishing to advise on structured products will need to apply to the FCA to have their permissions amended.

Having established that a customer is willing to take at least some investment risk, the following suitability factors should...

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...n several measurements of an index or of asset prices during the life of the investment. Although this provides extra security to the investor by protecting them from short-term falls in a level or asset value, averaging also prevents exposure to the full amount of any gains

Although a product may be linked to the performance of a stock market index, investors do not receive any dividend income from the companies that make up that index

The tax treatment of the product depends on its legal structure and any tax wrapper within which the product is held. The tax status of the client, both at the point of investment and when the product is due to mature, must be taken into consideration and the impact of taxation on the returns from the product properly investigated. Changes to tax legislation during the term of a product can also have a detrimental effect on the eventual return at maturity

Structured products in the UK are provided in one of several wrappers that determine how much tax investors will have to pay. The most common forms of wrappers in the UK are Medium Term Notes (MTNs) and deposits. There has also been a recent emergence of structured products held within Open-Ended Investment Companies (OEICs) or funds.

These vehicles can also be held with ISA wrappers (either Stock & Shares or Cash) to improve tax efficiency.

MTNs

MTNs are...

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...as a wrapper to allow the investor to enjoy tax-free returns on their investment. Two types of ISA are available – stocks and shares and cash. Products with an investment term of less than five years are not eligible to be sold as a stocks and shares ISA.

These products can also be purchased through a pension wrapper, although care should be taken to ensure that the terms and conditions of the product do not infringe the HMRC permitted investments regulations.

The risks associated with structured investment products are varied, depending upon the terms being offered. It is, therefore, vital that investors are ...

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...structured products can be held. Those products which are subject to capital gains tax on gains made would often be attractive to higher rate taxpayers.