12 Oct 2015 Structured Products – Low Risk With Gearing
A structured product is a pre-packaged investment product based on an underlying instrument like a single share or a basket of shares. In many cases the product will provide a capital guarantee if it is held to maturity plus enhanced gearing in the upward performance of the underlying instrument, capped at a maximum profit.
How did they originate? Structured investments arose from the needs of companies that wanted to issue debt more cheaply. This could have been done by issuing a convertible bond—i.e. debt that could be converted to equity under certain circumstances. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors would accept lower interest rates in the meantime.
Let’s look at an example currently on offer on our website, the Investec USD Wealth Accelerator. The product is designed to offer geared returns on the S&P 500 Index in US Dollars over a 3.5 year investment term. The USD Wealth Accelerator will provide Investors with 2 times the growth in the S&P 500 Index to a cap of 27.5% in USD (max return therefore 55%). In addition, the USD Wealth Accelerator provides the Investor with 100% Rand Capital Protection at maturity. The minimum investment is only R10,000 and increments of R10,000 thereafter.
The S&P 500 Index, or the Standard & Poor’s 500, is an American stock market Index based on the market capitalisations of 500 large companies listed on the NYSE or NASDAQ. The Index provides Investors with exposure to internationally diversified sectors and companies.
How does the principal protection work?
At the Maturity Date if the Index has fallen, the Investor receives his full capital back in Rands on condition that there is no credit event in respect of FirstRand Bank Limited as Reference Entity. The chances of either Investec or FirstRand Bank going bankrupt are quite slim.
How does the Gearing Work?
At the Maturity Date, the Investor receives 2 times the growth of the Index to a cap of 27.5% in US Dollars. For example, if the Index has risen by 20% the Investor will receive a return of 40% (2x 20%). However, as this investment return is measured in USD, if the Rand has depreciated by 10% from say R13.50 to R14.85, the Investor receives the geared return of 40% converted back into Rand at R14.85 for a 44% total return. Similarly, if the Rand has appreciated by 10%, the return will be 36.00%.
This is a JSE listed instrument and as such, the Investor will receive payment of this return in Rands. Investec will make a daily price in the instrument so that investors can sell the instrument before the end of the 3.5 year term. The daily price of the Wealth Accelerator is subject to various factors including volatility, prevailing interest rates, exchange rates and market levels, and Investors should be aware that the capital protection is only available at maturity.
The table below shows examples of the potential returns of the Wealth Accelerator at the scheduled Maturity Date based on an initial investment of R100 000.
Initial USD/ZAR R13.50
Gearing 2 x
Because the investor does not receive any dividends, where will he or she break even?
This is illustrated as follows:
If an Investor invests directly in the S&P 500 ETF, which increase in value over the Investment Term by 4.78%, the Investor would receive: 4.78% return + 4.78% in dividends = 9.56%. Similarly, an Investor in the Wealth Accelerator product over the Investment Term would receive: 2 x the 4.78% return = 9.56%. Note: This calculation ignores the effects of currency movement as well as taxation. Please see the Brochure for an explanation of tax implications and risks, but in general investors should not be subject to Income Tax, only Capital Gains Tax.
Does the issuer take a lot of risk and how does it work?
No, the issuer would normally not take any risk. The issuer will buy a Zero Coupon Bond that will guarantee the capital (bought from FirstRand Bank). Because the Bond costs less than the amount of capital invested by the investor, the balance (after costs) is used to purchase options on the Index ETF to ensure the geared performance. By selling options at the maximum profit level (27.5%), the issuer use the proceeds to buy more options creating double the exposure to the upside, but capped at the maximum profit level (2 X 27.5% = 55%).
Structured products sound very complicated, but are easy to invest in. It is a viable product for investors seeking capital protection and geared upside. To invest you will need to open an account with a broker like Sanlam iTrade. The offer is open for investment and will close at the end of October. You can register online as an iTrade client (not iView) on our Website.
– Head Sanlam iTrade