Structure notes - Up the creek with a paddle

Recent years have witnessed a steady increase in the amount of capital guaranteed products hitting the advertising pages of the Gulf News and other dailies.

The "product sales" space is taken by promotions aimed at protecting capital first and promising returns second. Such has been the effect of the 2000 to 2003 systemic crash.

As a generic group, the products typically offer "capital protected" options.

This is a guarantee that, over a specified period (or an unspecified period, if there is a "call" clause), the investor will leave the field of play with at least the money he brought to the party.

Post-2000, this seems too many like a nice little feather bed on which to play the rough and tumble of the markets.

There are risks, aren't there always? Yet they don't compare to the cataclysmic drops endured in the "blue chip" equity markets post-2000.

These risks can be herded into a pen headed "cash and inflation".

If the capital protection is actually required, than something has clearly gone wrong with the investment.

Under such a scenario the investor will receive his original money back. This means he will have lost on two fronts: front one, the loss of bank interest over the period of the guarantee, and the loss of purchasing power as the cost of goods and services rise in that period.

In a rising interest rate environment, such as today's, the issue has some relevance.

Buing options

Steve Corrin at Anglo Irish described the firm's new offering as a "paddle" that will help risk adverse investors, and investors planning their "low risk" portfolio component, navigate streams and creeks where once there were only boats and currents.

The new "Privilege Multi-Asset Bond" is a case in point.

"Technically, it's a four-year structured deposit", said Corrin.

"Anglo Irish holds the cash for four years and uses the future interest to buy options on underlying indices.

A US dollar investment of, say, $100,000 (Dh367,000), might generate $12,000 (Dh44,040) interest four years at three per cent interest.

The $12,000 (Dh44,040) is used to buy options in underlying indices," he said.

Isn't this a quite intelligent use of the bank's position as a deposit taker?

The win/win scenario comes from the investor's $100,000 (Dh367,000) being actually safe in the bank vault, with the cash strength of the bank being utilised to buy the options "up front". This leaves the bank's gain as the ability to lend the $100,000 at a margin for four years.

The sceptics are going to say: "The bank has gotta be making more than this".

To which Corrin replies: "Nope. One of the features of this product structure is that there is no need to buy a fund manager. No bid/offer spread, no management fee, no exit penalties. We make our money by lending to borrowers as part of our usual treasury/banking business".

Some will ask whether this sort of suggests there is not much skill involved, as nobody is getting paid. The question gains more credence when you look at the underlying indices of the Privilege Multi-Asset Bond which are options on the following predictions: that the US dollar will be higher than sterling in four years; that oil prices will strengthen and that either the FTSE (for sterling thinkers), or the Nikkei (for US dollar thinkers) will be stronger in four years. This is where the $12,000 of investment largely goes.

Dollar thinkers

How good a call is this? We will have to wait and see, but if you get it right the "participation rates" are fairly good. For dollar thinkers, a win on the average of the three indices will give you a 150 per cent participation in the performance.

For sterling thinkers, the participation for investors will be as high as 180 per cent.

In other words, the headline news for this particular product is the relatively high participation rate received by investors, if the three indices average out a gain, and if there is no need to rely on the guarantee.

In comparison, a more recent equity-based structured note manufactured by Anglo Irish provided a participation rate of only 85 per cent.

When you add in a loss of liquidity of six years, the risk of all the main equity markets (United Kingdom, United States, Japan and Europe), the offering under the Privilege Multi-Asset Bond looks a lot more appealing four years versus six, higher participation rates, together with a more genuine diversification of risk by averaging the results of three totally uncorrelated arenas for performance.

The problem with this performance environment, of course, is that we cannot judge it for four years.

So, in the meantime, its allure remains the prospect of entering into the highly volatile waters of oil, currency and equities, safe in the knowledge your paddle will not break and your boat will get to a fairly safe haven.

You will also retain the prospect of drifting somewhere much more exciting.

The writer is the managing director of Mondial (Dubai) LLC.