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Defined returns explained

How does a defined return product work?

We are often asked how the defined returns products we invest in work. 

What is a defined returns product?

Defined returns are a type of structured product also known as an “autocall”. They are provided by investment banks who create them by packaging together various financial instruments in order to obtain the return.

For example, we recently invested in an autocall with Morgan Stanley. This was set up on 27 January 2017 when the FTSE 100 was at 7,185 and the S&P 500 was at 2,294.

The product can run for a maximum of six years and will provide a pre-defined return on given dates, in a given set of circumstances.

If both markets are above their start level on any of the first six anniversary dates, the product will end on that date and provide the return as set out below. If the markets are below the start level on the anniversary, it rolls on to the next one:

  • 1st anniversary – 27 January 2018 – 11.55% return
  • 2nd anniversary – 27 January 2019 – 23.10% return
  • 3rd anniversary – 27 January 2020 – 34.65% return
  • 4th anniversary – 27 January 2021 – 46.20% return
  • 5th anniversary – 27 January 2022 – 57.75% return
  • 6th anniversary – 27 January 2023 – 69.30% return

 

At the end of the six years, if the product has never “kicked out” because the markets have not been above their start level on an anniversary date, investors get their original capital back UNLESS one or both of the markets is down 40% or more on that day. If the markets are below this “barrier” then investors lose money in line with the worst performing market. If this is down 42% on the maturity date (for example) then investors lose 42%.

Why invest in such a product?

We like to use these products as they provide potentially a good level of return even if markets essentially go sideways – markets don’t actually need to go up in order to achieve their return.

We also like the element of capital protection and that we have multiple “chances” to achieve these returns. We especially like this when equity markets look expensive, as they do at the moment in our opinion.

However, there are of course downsides to these products and they may not be suitable for all investors. Not least, if markets go up more than the rate of return on the product we would have been better buying a tracker fund. In addition, the products have counterparty risk.

With the above example, by buying the product you are exposed to the risk that Morgan Stanley might not be able to pay the stated returns, or return your capital. The products are not covered by the Financial Services Compensation Scheme (FSCS). Given these risks we limit investment in such products to typically a maximum of 3% to 5% of a portfolio per provider. They are also normally held as part as an overall portfolio, which contains a diverse range of asset classes.

Yes, but how does it ACTUALLY work underneath the bonnet?

There’s two ways of answering that question, the technical and the non-technical answer!

The technical answer

Underlying the product is a combination of security and derivative transactions. These include:

  • Buy a zero coupon bond. This is a bond which produces no income but which will provide a capital gain over the term.
  • Buy contingent call options. A call option is an option to buy an instrument at a set price at a set date in the future. You would of course only do so if that price was lower than the market price at the time. The “contingent” part is that the option premium is only paid should the option be “in the money”.
  • Sell knock-in put options. A put option is an option to sell at a set price on a set date in the future. The “knock in” part means the option premium only becomes due at that level.

 

By structuring a product to include different combinations of the above, the investment bank knows exactly what return it will get in a given set of circumstances.

See, I told you it was technical!

The non-technical answer

The security we purchase when we buy a structured product is essentially a bond.

If we bought one of Morgan Stanley’s corporate bonds we would be lending them money. In return, the bond promises to pay a set amount of interest and will mature and return our capital on a set date in the future.

The defined returns product is similar, it’s just that the date of maturity and the return is dependent on the level of the stockmarket at given dates.

In both instances we are essentially entering a contract with Morgan Stanley. In many ways it doesn’t matter HOW they can afford to pay the return only that there is a contractual obligation that they do so. In both instances our capital is at risk if Morgan Stanley goes bust and can’t pay its obligations.

Ok. So what’s in it for the investment banks?

Essentially, they make a small spread (perhaps 1%) on each of the products that they write. They make this spread regardless of whether the product makes any money for the investor.

Because they write a large volume of such products this can be quite lucrative even if the margins are quite small.

 

The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.