Quick guide to structured products
If you're thinking of buying a structured product, each will require detailed examination. Here we assess the key features, advantages and disadvantages of the concept and explain how to check whether they are right for you.
A structured product may sound like something you could wear to counteract middle-aged spread; in fact, however, it is a generic term to describe a type of investment which usually has a fixed term, offers some capital protection and, subject to various conditions being met, a predetermined return on capital.
A few years ago they were being actively promoted by banks and building societies, but a series of scandals in the wake of the financial crisis and some regulatory attention means that they are becoming less common on the high street, although they are still widely available through other channels.
We offer a guide to their key features, advantages and disadvantages and explain how to assess whether they are right for you.
What is a structured product?
Structured products are investments whose returns are based on the performance of an underlying instrument, such as the FTSE 100 (UKX) or other index or a basket of shares. They can be called a variety of names - Guaranteed Equity Bonds, Structured Cash ISAs, Protected Investment Bonds or Growth Deposit Plans are some of the more common descriptions.
There are two main types: structured deposits and structured investments.
These are, as the name suggests, deposit accounts but, unlike conventional accounts where the rate of interest depends on prevailing base rates, the returns will be linked to the performance of some other index or asset, commonly the FTSE 100. For example, the return may be a multiple of the performance of the FTSE 100 - say 120% of its rise - usually with a cap; or will promise a specific rate of return - say 6.5% a year - provided the index rises by a particular amount. Some will offer no interest at all if the index falls below a set figure but your original investment will be secure.
These will usually have a fixed term and, as deposit accounts, will often be covered by the Financial Services Compensation Scheme (FSCS) which protects up to £85,000 of deposits. The rest of this article, therefore, mainly refers to structured investments, which do not have such guarantees.
These are also generally linked to an index but, unlike deposits, will not be covered by the FSCS. Some products have capital protection, which means investors will not lose their initial stake (but see counterparty risk below); others put the initial capital at risk. They will have a fixed term, although some have the potential to pay out early if the predetermined targets are reached.
There is a huge variety of types of product. They range from those offering a preset annual return provided the FTSE 100 rises each year; to products promising a fixed return if the index never closes below a set level during the life of the investment; to those offering returns based on the performance of a number of different indices or baskets of shares, such as the largest in the FTSE 100 or companies in a particular sector.
The products work by using derivatives to achieve the promised return: the initial investment will be divided three ways: to buy into a savings product designed to return the capital at the end of the term; to buy a financial instrument which will be used to produce the promised return; and to cover the provider's fees. The return can be annual, as income, or paid only when the fixed investment term ends.
Many investors are, however, unaware that these products have what is known as counterparty risk as they are effectively loans to an investment bank - a bank whose identity may only be revealed in the small print and who may be different to the firm which is actually promoting the product. The bank provides the investment and derivatives behind the product, which means the investment is heavily dependent on the financial stability of that bank - and the financial crisis means that banks can no longer be considered 100% safe.
Indeed, many structured product investors lost substantial sums when Lehman Brothers, which was counterparty to a large number of them, collapsed in 2008. Scandals like these led to fines for some market players, including Credit Suisse, and to guidelines from the Financial Conduct Authority about how they should be promoted and sold.
- Returns: When interest rates are low, stockmarkets volatile and bonds (particularly investment grade and gilts) looking expensive, the returns available on structured products can be attractive.
- Flexibility: There is a wide range of structured products based on different indices and offering returns in different ways and over different time periods. Some will pay an annual return, provided the targets are met; others will roll up the return and pay out at the end of the term. The level of risk also varies depending on the underlying index chosen. That means investors can tailor a portfolio of structured products to reflect their risk appetite and time horizon.
- Downside protection: Many structured products offer some downside protection so, for example, investors' capital will only be at risk if the chosen index falls by more than 50% and losses will be tapered after that, depending on the extent of the fall.
- Tax: The return on growth products may be treated as a capital gain and subject to capital gains tax (CGT), rather than income tax. That means investors can use their generous CGT allowance - £10,900 in the 2013-14 tax year - to shelter profits. Any gains above that allowance are taxed at 18% for basic-rate taxpayers and 28% for higher-rate taxpayers.
- Lack of liquidity: Structured products generally run for a fixed term. There is a secondary market for some structured products but not all and, even among those which can be traded, investors may not get all their original investment back.
- Costs: The costs of these products may not always be clear but they can be expensive: charges of 7% or more are not uncommon.
- Risks: While betting that the FTSE 100 will rise by a set percentage each year may not sound that risky, the experience of the past 10 years shows just how volatile markets can be. The target figure may have to be reached on a particular day, which makes them vulnerable to unexpected events which have a short-term market impact. The more complicated the product, the higher the risk is likely to be: a product linked to several exchanges, for example, will carry more risk than a single index one; a product linked to individual shares will be riskier still as anything from a change in management to actions by competitors can affect the share price.
- Inflexible: While you can sell funds or shares if you change your view of markets, you cannot make any changes to the way the structured product is set up.
- Limited upside: The return on structured products is generally capped so that, if markets soar, investors will not generally reap the full benefit.
What you need to consider
- Counterparty: How stable is the bank behind the scheme? What is its credit rating?
- Level of risk: What is the product linked to? The more indices or the fewer individual shares, the higher risk it will be.
- Targets: How ambitious are the targets which the product has to meet? The more the index has to gain, the less likely it is that it will be achieved.
- Capital at risk: How much capital will you lose if the index does not perform as hoped?
- Tax treatment: Will the return be subject to capital gains or income tax? Is income paid net or gross? If it is the latter, you will have to fill out a tax return.
- Charges: What are the costs of the product?
- Penalties for early redemption: How much will it cost you to get out?
Structured products have their own technical vocabulary. Here are definitions of some of the more technical terms:
Barrier: In a Capital at Risk product, the barrier is the level of the index or other measure which must be breached before losses are incurred.
Capital at Risk: Products where there is the chance of losing money at maturity.
Capital Protected: The original capital will be returned regardless of what happens during the term of the product.
Counterparty: The bank or other financial institution which provides the instruments underlying the structured product.
Downside: The rate at which losses will accrue after the barrier is breached.
Kick-out or Auto-Call: An investment which can end and pay out before the stated term if a particular event occurs, for example the relevant index is above a predetermined level.
To find out more about these investments, visit our Structured Products Centre.
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