PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS

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1 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS CUBE INVESTING David Stuff ABSTRACT Structured products are an attractive type of investment for income seeking investors. They offer the potential for a high regular income with clear and measurable risks. We describe in this note how structured products, prudently selected, can form part of a well designed retirement portfolio.

2 2 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS SUMMARY - Structured products can offer a regular income with clearly defined risks to both the final capital value and the coupon - The income offered can be higher than the income available from long-only investments in equities and bonds - Products can be created to suit the needs and requirements of different investors - Like all securities, structured products carry risks, specifically market risk and counterparty risk. These must be carefully considered and balanced against the returns. INTRODUCTION The new freedoms that investors have to invest their pension assets means that many investors are looking for assets that offer a regular income. Structured products are one investment choice that can meet this need. Reverse convertibles of one sort or another have been a popular product for a long time, and their popularity is increasing now. Reverse Convertibles offer a regular coupon (that may be conditional on the underlying assets remaining above a performance benchmark at the time of the payment) and the investors capital will be returned provided that the underlying assets are above a threshold level at the maturity of the note. When developing products for this particular market segment we need to balance the income that investors receive against the risks that they face. In the section below we consider the 3 main variables that we can adjust when developing products;; - The way that the income is defined, - The term and - The risk that the investors face to their capital at maturity. One of the principal benefits of reverse convertibles is that when the investor faces a risk to their coupon or capital, this risk is clearly defined. The conditions that have to be met for the coupon to be paid and for their capital to be returned in full are described, and these risks can be quantified. This makes reverse convertibles one of the cleanest and easiest income generating products for investors to evaluate. We provide indicative pricing on a range of different shapes that offer attractive levels of income that we hope will provide the basis of a discussion that will lead to the development of actual products for your clients. APPLICATIONS A range of income seeking investors use Reverse Convertibles as part of their portfolio. INCOME FUNDS Reverse Convertibles may be used as well as, or instead of covered calls. Reverse convertibles offer more flexibility than covered calls. - Investors have the ability to specify the coupon amount and frequency. - Reverse convertibles also allow investors to take advantage of knock-in puts which offer investors a degree of protection that they will not get from a covered call strategy. - Reverse convertibles can be based on single assets, baskets of assets or the worst of a number of assets. - Reverse convertibles can be structured with a term of up to 6 years on most assets, and even longer on some indices. 2

3 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS 3 CAUTIOUS FUNDS Many reverse convertibles offer a very stable, low-volatility investment profile. The analysis we have from Investment Product research illustrates that the volatility of annualised returns can be between 4% to 8%, depending on the detail of the product. The combination of a steady return and low volatility can make these products suitable for cautious growth or income funds (for growth funds the coupon can be rolled up in the structure and paid at maturity as part of the maturity value). PORTFOLIO MANAGERS For many private clients, and particularly those in retirement, Reverse Convertibles offer a very appealing combination of high income and a degree of protection. The soft protection built into most products means that the maturity value will be 100% unless the underlying assets have fallen by 35% to 50% over the term of the product. Reverse Convertibles are an income-generating asset that can offer a much lower chance of loss than other income generating investments. INCOME Reverse convertibles allow us to specify the payment schedule that meets the needs of the target investors. We can specify the amount, frequency and timing of each payment. We can specify conditions that have to be met for coupons to be paid, and the underlying variable that may be used to determine the amount of any payment. REGULAR INCOME The base case is for investors to receive a fixed regular payment, ideally monthly to replicate the paycheck that they have been used to when they were working. The simplest income payment schedule would be a flat coupon to be distributed at regular intervals. NON LINEAR PAYMENTS A pre-determined coupon payment schedule could be more imaginative;; variations that may appeal include: - A schedule that pays more at times of the year when there is typically more expenditure (Christmas and summer) - A schedule that rises steadily over time VARIABLE COUPONS; INFLATION AND RATES Given the prospects for rising rates we think that investors may like a coupon that is linked to dividends, rates or inflation. DIVIDENDS Our favorite link is to set the coupon payable by reference to realised dividends. A product may offer a multiple of the dividends that are paid, or offer a coupon that is equal to dividends paid + XX%. The dividend link works for a number of reasons - Implied dividends often look very low compared to analyst s forecasts. This is partly because of technical reasons in the derivative markets. - Investors have a direct comparison with equity income funds. The dividend linked product will offer a higher yield and soft protection. The equity income fund will offer the possibility of growth - If realised dividends turn out to be greater than the implied dividends, the coupons paid out will be greater than the coupons that would have been received from a fixed rate product. The only problem with a dividend-linked product is the lack of liquidity in the market for dividend forwards. This limits the term of a dividend-linked product. 3

4 4 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS RATES AND INFLATION A coupon that was described as GBP 3m LIBOR + XX% would offer an income that increases as interest rates rise. A more attractive alternative would be to offer a coupon linked to Inflation;; UK CPI + XX% would maintain the real buying power of the income that the investor receives. When we have looked at rate linked products the starting coupon can seem quite low. The key consideration for investors is the level of 3m LIBOR that is implied in the current swap curves. Figure 1;; GBP 3m Forward Rate Forward 3m LIBOR Source IPR;; rates as at 17 th September 2015 The chart shows that markets are discounting an increase in rates, and it is these implied payments that drive the pricing of a floating rate product. What investors have to think about is if they think that interest rates will be higher than the implied rates. If investors think that rates will be higher than implied rates then the floating rate product will be attractive. A product that has a pre-determined coupon will be more attractive to investors that think the implied rates are not going to be realised, and that rates will stay lower for longer than the markets. CONDITIONAL COUPONS A conditional coupon is one where the payment is made only of the level of the underlying assets meets a minimum criterion. Typically the level of the underlying would have to close above a specific level at a set observation date for each payment to be made. If the income payments are conditional because there is a risk that the coupon may not be paid the coupon that may be received will increase, but investors have to accept the chance that they don t receive a coupon. Having said that even a low barrier for the coupon payment like 60% can offer a noticeable increase in the coupon that may be paid. There is an almost linear relationship between the coupon barrier and the coupon that may be received. 4

5 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS 5 Figure 2;; Coupon payable / coupon barrier 6.0% 5.0% Annual Coupon 4.0% 3.0% 2.0% 1.0% 0.0% None 50% 60% 70% 80% Coupon Barrier Source IPR;; FTSE 6 year reverse convertible with 60% EDIP showing the coupon with no barrier, 50%, 60%, 70% and 80% coupon barriers (50basis points funding, 97% fair value) One variation we like is where there is both an upper and a lower barrier for the coupon to be paid. This is similar to a range accrual. Introducing an upper barrier can offer a good uplift. Making each payment conditional on a single observation is arguably simpler to understand. Also if the coupon is missed because the upper barrier is breached, the investor will have made a reasonable capital gain on the remainder of their portfolio and the dividends from their equity income holdings may have increased as well. TERM Our thoughts are that of the things that can be done to increase the coupon, investors would generally prefer the risk that a product may mature early to a risk to the coupon. Products that call early will pay a higher rate than standard reverse convertibles, and these structures avoid a void income period. Investors have to be prepared to reinvest their money, and accept the risks that the rate may not be so good. They also need to recognize that the level of the underlying index will probably be higher when they reinvest than when they first traded. An Autocall feature in a reverse convertible acts like a cap. Unlike a normal Autocall, the investor is receiving the income on a regular basis. The Autocall simply serves to reduce the term of the product in the event that the level of the underlying has increased (so reducing the value of the put). Because of this the incremental coupon paid will be reduced as the Autocall trigger increases. The less likely it is that the Autocall will be activated, the smaller the increase in the coupon payable over a non-callable product. Recently we have had demand for products with Autocall levels of 105% and 110%. Compared to a product that calls if the underlying is over 100%, these out of the money Autocall levels offer investors a wider channel in which they will harvest the coupons while also offering some uplift in the coupon payable. COMBINATIONS Combinations of non-standard coupon schedules with Autocall features are used to generate products that offer the possibility of high coupons. CALLABLE CONDITIONAL INCOME Autocall products with conditional coupons are popular with investors, and have become almost standard in some markets. We have arranged a number of issues with 80% coupon barriers and 110% triggers. 5

6 6 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS Investors can look at these shapes as being equivalent to a callable range accrual. Both the coupon barrier and the call feature will increase the coupon payable. Investors should be aware that the volatility of annual returns offered by these products will be higher than products that only have one of these features. The extra volatility is a price that investors have to pay for the additional return. DOUBLE BARRIER RISING COUPON We have looked at products where the coupon increases over time, and where the payment is conditional on the underlying remaining within an upper and lower band. The coupons will start out lower than a flat payment schedule, but the coupons paid at the end of the term will be higher. The sum of the coupon payable is greater if there is an increasing schedule compared to a flat payment. The increase in the total coupon is because the pricing models used by the traders will imply that there is a lower chance than the later coupons are paid. These coupons are cheaper and so the maximum will increase. This shape will work for investors that have a strong view that the underlying will remain within the range. It will also work as part of a more diversified portfolio of income generating assets because the shape will offer a high return in market environments where other assets will not be performing well. UNDERLYING ASSETS AND BARRIERS We suggest that many investors that are targeting a specific level of income are prepared to accept a greater risk to their capital if this results in less risk to the income that they receive. This is after all the trade-off that is implicit in most other income generating products and strategies. Many advisers will set cash aside that is drawn down over a number of years while the remaining assets are invested in the hope that growth will make up for the income that has been taken out. Increasing the barriers from the normal 60% level will increase the coupon payable. Even an 80% barrier offers significant protection against loss. An at the money put with no barrier offers the same risk as an equity income fund and should not be discounted as a possibility. Dual index and triple index products will also offer a higher coupon because there is a greater risk that the final value will be less than 100%. Multi index products can be significantly riskier than equity income funds and so portfolio managers will need to show that they understand the risk. We can calculate the delta to each market for investors that need to show the exposure that they have to each geographic area. INDICATIVE PRICING The table below illustrates the monthly or quarterly coupon that investors could receive from a selection of income paying reverse convertibles. These are all shapes that we like, and which we think will appeal to different investors. These indicative prices have been calculated by Natixis. The table shows them in escalating order of maximum annual income: Figure 3;; Indicative pricing Capital Risk Term Income Annual Rate FTSE 60% EDIP 6 years 0.38% per M 4.57% FTSE 60% EDIP Autocall annually if FTSE > 110% 1.16% per Q 4.64% Worst of FTSE / SPX / 6 Years 0.45% per M 5.34% SX5E 60% EDIP FTSE 60% EDIP 6 years 0.46% per M if FTSE >60% 5.52% and <140% FTSE 100% strike put 6 Years 0.47% per M 5.64% FTSE 60% EDIP 6 years 1.56% per Q if FTSE > 80% 6.24% FTSE 60% EDIP Autocall annually if FTSE > 110% 0.64% per M if FTSE > 80% 7.68% 6

7 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS 7 Worst of FTSE / SX5E Autocall annually if FTSE and SX5E 60% EDIP > 110% Source;; 22 September 2015, CUBE Investing / Natixis 2.25% per Q if FTSE and SX5E > 80% 9.00% COMPARISONS How do these coupons compare with other investments? In the first instance we can compare the coupons offered by these products against yields from other investible assets. Below we show the yield from a range of ishares. Figure 4;; Yield on various ishares Market Ticker Yield UK Government 5 year Gilts IGLT 2.10% Investment Grade corporate bond IS % High yield corporate bond SLXX 3.49% FTSE Dividend yield ISF 3.83% Emerging Market debt SEMB 4.51% Emerging market corporate bonds EMCP 4.54% Euro High Yield Corporate Bond IHYG 4.55% Equity income IKUD 5.37% Source;; 22 September 2015, CUBE Investing / It is clear from the yields available on this selection of ETF s why equity income funds are so popular. By comparison to these funds the reverse convertibles above look very attractive for investors that want income, and to reduce the chance that they suffer a loss. The reverse convertibles above offer the possibility of higher income, and in most cases offer substantial protection against a capital loss. 4.57% per annum from a vanilla reverse convertible linked to the FTSE with unconditional coupons and 40% soft protection compares favorably with 3.83% from the FTSE tracker (no protection but the possibility of capital gains). Post retirement income seeking investors need to preserve their capital value, and so many will prefer the maturity profile of the reverse convertible to the FTSE tracker. PRODUCT ANALYSIS As the maximum annual coupon increases so do the risks - There is a greater risk to capital at maturity - There is a risk that the coupons may not be paid It is important for investors to understand the magnitude of these risks and the effect that they have on the return that investors may expect and the overall volatility of the investment. One of the benefits of structured products is that the risks are clearly defined and articulated. We can model these risks using a model for the underlying index, and use the output from this model to estimate the overall risk and return. We can use the analysis offered by Investment Product Research (IPR) to illustrate the actual returns that investors may receive, and the risks that they face. The expected return is the probability and time weighted average return from millions of stress tests. It takes into account the chances that coupons may not be paid, the chance that the maturity value may be less than 100% and the investment term. The volatility is the volatility of annualised returns. It is a semi variance type calculation that uses the average return, and the average of the worst 10% of the results in the simulation. 7

8 8 PROVIDING RETIREMENT INCOME WITH STRUCTURED PRODUCTS CONCLUSIONS Every investor and portfolio manager will have different thoughts about the best product shape. Different investors have different needs, and products will be used as part of a broader portfolio. CUBE offers specialist product development skill and experience. We work with fund managers to develop and test products, and to find the best issuer for each product. Our view is that for retirement income, it is the income that is the most important feature. We think that investors who want a higher income would rather take more risk to their capital rather than risk the income that they receive. So with this in mind our thoughts would be to increase the coupon payable in this order - Use multiple indices as underlying assets - Increase the put barrier - Introduce an Autocall feature - Make the coupons conditional CONTACTS David Stuff Tel;; ;; david.stuff@cubeinvesting.com DISCLAIMER The IPR data reported above are based on research on the performance of the investment products listed, commissioned by CUBE from an independent company, Investment Product Research Ltd ( IPR ). If you require access to more detailed research, or want a full description of IPR s calculations, please visit You will be required to register to access IPR uses its proprietary methodology to create approximately 5 million simulations of how the investment product may perform in the future;; each simulation is based on a different re-ordering of the historical daily price movements of the underlying index (or indices) since the start of The time span includes periods of both positive and negative performance of stock markets, so we consider it a useful data series on which to base simulations of market performance. The tabulations and charts below provide indications, based on these simulations, of the likelihood that the products will generate different levels of return. We also indicate for comparison the likelihood that the products will generate a given return based on a simple historical back-test, a customary measure of possible future performance based on the assumption that the future will replicate a period of past performance (again, the historical period used to generate the historical back-tests is the period since 1993). The IPR simulations are a more comprehensive test than the historical back-test: the great majority of the 5 million IPR simulations are not simple repetitions of a period of past performance. The general effect of the IPR simulations is to produce more conservative indications than the historical back-test of the return you may achieve on your investment. However past performance of markets is not a reliable indicator of future performance, and should not be relied upon to make investment decisions. Additionally, neither the IPR analysis nor the historic back test take into account the possibility that the issuer may default;; if the Issuer defaults you will lose some or all of your money regardless of the future performance of markets. This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. It neither covers all products available in the market nor is it intended to provide advice on the investment suitability or otherwise of any of the ones reported. This document is intended for financial advisers and qualified investors only. It includes research produced by IPR to help evaluate the products. It is the responsibility of the reader to determine whether they are suitably qualified and have the correct regulatory permissions to act in regard to any product mentioned in this document. Private individuals who are not qualified investors should seek the advice of a financial adviser and read the separate product brochure before making a decision to invest. This document should not be distributed to private individuals who are not qualified investors. IPR provides research service for structured investments available to UK investors. Full details of the service offered, together with the Terms and Conditions of the service, please visit the Users may have to register to obtain full access to this website. IPR reserves the right to alter or discontinue this service at any time. The research included in this document is based on information from sources that IPR deems reliable, but IPR and CUBE make no guarantee that the information is complete or accurate and it should not be relied upon as such. Information included in this document is correct as of the date of this document, however is subject to change. No liability whatsoever is accepted for any losses incurred from using the research included in this document. All prices shown are indicative only and do not imply an offer of any kind. None of the research included in this document can be reproduced without the prior written consent of CUBE. 8