Structured Perspectives
Range accrual - an alternative Payoff
By Adrian Neave, Managing Director Gilliat Financial Solutions
1 December 2009
Throughout the recent travails of the Structured Product industry we have been reassured to see sales continue and we have also received enquiries from advisers that have not used structures in the past so there must be some truth in the old adage that any publicity is good publicity. I still get annoyed reading comments on the products, both individually and generically, from people who clearly know little or nothing about these products. It would be nice if these detractors would sit down and discuss their ‘objections’ with better informed people and establish whether there is any validity to their claims that structures are ‘toxic’ (bet they didn’t have any clients in money market funds with Lehman exposure, NOT) or that in a bull market structures will under perform.
It is this last point that gave me the idea for today’s diatribe.
In the retail space the pay-offs that we see are usually no more than tweaks on the standards:
- Capital protected growth plans
- Reverse convertibles (the income plans)
- Call spreads (capped, geared growth plans)
- Autocallables (kickout plans)
I believe that many advisers are unaware of the variety of other payoffs that are available. Some of these do occasionally find their way into the retail market for a brief period before disappearing. Is this because they are bad products or because people don’t understand the returns or see how they might be used?
One pay off that does occasionally make an appearance and then runs back to its burrow to hide for a while is the range accrual or synthetic zero as they are sometimes known.
These arrangements are useful when a client is willing to take on some asset risk but either expects volatility but no trend or expects a modicum of movement but is unsure of the direction. Obviously in the retail space the asset is usually FTSE but there is no reason why this pay off cannot be used with other assets that are expected to range trade, or not to trend strongly in one direction.
A typical product might work in the following way:
- Assuming the index is at 100 a soft protection barrier at 50 is in place meaning that, unless the index halves or worse, (the worst case return would be 100) the original investment capital is returned in full at maturity. If the index more than halve then the return would depend on the end index level (losses matching the index on a one for one basis) plus the amount of bonus accrued.
- For each day the index is within a specified range then there is a small bonus coupon accrued. This increases every day that the index remains in the range. If the index moves outside the range then the bonus stops accruing. If the index moves back in to the range then the bonus starts accruing again.
- The levels between the index has to trade for the bonus to be accruing could be 50 to 140 in present conditions on an index such as the FTSE or EPRA (property), with a maximum return in the order of 55% (full return of capital and 55% bonus). Assuming a six year term this equates to a compound annual return of 7.57%, and should be treated as a capital gain, so attracting the benefits of CGT treatment, favourable relative to income tax rates at the present time.
Range Accural in action
This graph uses fictitious figures to demonstrate the range feature of the product and how the performance of an index might affect the investment return.
There are other pay-offs that I think are attractive at the moment, those with a best entry feature, or averaging on the way in, in particular. These and the range accrual described above can work with a variety of assets, not just the FTSE.
As always we welcome feedback on our thoughts and any ideas for future topics that you would find of interest.
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