Structured Products Offer Compelling Opportunities in Turbulent, Low Yield Market

By David K. Donovan Jr. Federal Reserve Chairman Ben Bernanke recently said the U.S. central bank would spare no effort to boost weak growth and lower unemployment. Almost three years ago, the Fed cut its benchmark rates to near zero to pull the economy out of a sharp recession, and on August 9, 2011, it eased monetary policy further by expanding its earlier promise to hold rates at rockbottom levels for an extended period, at least through mid-2013. While these recent Fed decisions help maintain the housing industry, they also present an opportunity. Despite todays low-yield environment, individual and institutional investors continue to want higher returns as they balance risk versus reward, with more yield compensating them for taking on more risk. In todays turbulent, low yield market, structured products or market-linked investments are becoming increasingly more attractive to both retail and institutional investors because they provide a compelling means of enhancing and broadening investment portfolios. Structured products are investments that include a derivative-linked payout backed by the issuers credit. Different forms include structured notes and certificates of deposit (CDs). They are distinctly different from asset-backed securities (ABS) and mortgage-backed securities (MBS), which are investments funded by a pool of loans. Because ABS/MBS are called structured finance, structured credit or securitization, the similar names can often cause confusion. Traditionally, structured products have been more popular in Europe and Asia. However, we expect their popularity to increase in the U.S. because of three factors: todays historically low global interest rates; institutional investors hunting for yield; and an available feature of builtin principal protection, which creates an attractive investment for the retail sector. In fact, according to a report in Investment News, $30 billion in structured products were sold in the U.S. in the first half of 2011 as compared to $53 billion in all of 2010 and $33 billion in all of 2007 which was considered a good year for the just burgeoning structured products marketplace. Fueling this growth is the ability of structured products to offer customized exposure to the market and meet specific investor needs that cant be met by standardized market instruments. As such, they can be used as an alternative to direct investments in equities in the S&P 500, mutual funds, exchange-traded funds (ETFs) or market indices like the Morgan Stanley Emerging Markets Index and as an asset allocation strategy to reduce the overall risk exposure of a portfolio. They are frequently offered as SEC-registered products, which make them accessible to investors just like stocks, bonds, mutual funds and ETFs and are a useful complement to those better-known products as part of a diversified portfolio. However, unlike mutual funds, ETFs and hedge funds, structured products are created and offered continuously, with specific maturity dates that can be personalized to meet a variety of investment objectives.

The two general types of structured products that are both principal protected and at the same time participate in some other market via derivatives are market-linked CDs, which are bank accounts that pay a derivative coupon, and structured notes, which are bonds that pay a derivative coupon. In the latter group includes a wide variety of structured products, such as equity-, interest rate- and FX and commodity-linked single name notes, baskets and hybrid blends. Market-linked CDs are fully protected by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per instrument, while structured notes are guaranteed by the issuer, which includes many of the worlds leading financial institutions. A Guaranteed Return with Reduced Volatility Investors are attracted to structured products because they can offer protection against market losses while offering higher yields, access to specialized asset classes and tax advantages. The full FDIC protection of market-linked CDs also makes them a very attractive principal-protected investment. Structured products are designed so they can never lose the value of the initial investment, with the upside that if the market goes up, they generate greater returns, and if the market goes down, investors still receive all of their initial investment. In other words, they guarantee a return of at least 100% of the original investment and have the potential to return much more while ensuring reduced volatility or risk. Specifically, principal protection guarantees the investor protection of principal if the note is held to maturity. For example, if an investor invests $1,000 in a structured note with a face value of $1,000 with a five-year maturity, the note actually consists of two components a risk-free bond that will generate sufficient interest to grow to $1,000 over the five-year period and a derivative. With the money left over after purchasing the bond at its original issue discount to face value, the issuer can purchase another product that will match the investment strategy. This may be swaps, options or another type of derivative. At maturity, the investor gets back $1,000 no matter what happens to the underlying asset. If the underlying value of the derivative asset is higher on the date of maturity than when it was issued, then the investor also gains that higher return on a nearly one-to-one basis. If it is not, then the investor only receives the original principal-protected $1,000. Mutual fund companies are increasingly looking at structured products as long-term investments that can boost their firms offerings to their customers. They can link a structured product to one of their flagship funds, for example, giving them another, new type of product that would increase their asset base. Structured products can bring many of the benefits of derivatives to investors that would otherwise not have access to them as part of their investment portfolios. However, with all investment products, it is vital that there is transparency so that more investors have access to sophisticated strategies like structured products in a safe and rational way. Our mandate as an industry is to make sophisticated products and investment strategies simple, accessible and understandable to all investors by driving down the barriers to entry through technology and the promotion of standards. -----

David K. Donovan Jr. is Vice President & Managing Director of Sapient Global Markets, a business and technology services provider to the capital and commodity markets. Previously, David K. Donovan Jr. was the Sector Leader, Technology Group, at Fidelity Management & Research (FMR). The preeminent trader at FMR, his vision and grasp of the intricacies of the global market enabled him to make key decisions across Fidelitys major funds. Disclaimer: The views and opinions expressed here do not necessarily reflect the views and opinions of Sapient Global Markets or any other company. www.davidkdonovan.com ###