In a bid to make the popular but unregulated and complicated
structured products more lucid for investors, the capital market regulator, the
Securities and Exchange Board of India (Sebi), last month issued guidelines on
additional disclosures for the issue and listing of these. Structured products
or market-linked debentures are products where majority of the money is
invested in fixed-income securities and the smaller portion in derivatives
linked to a assets such as equities.
Observing that these products are different from regular
debentures in nature and their risk-return relationship, Sebi felt the need for
additional disclosures and requirements in offer documents. The guidelines
broadly talk about disclosure norms for risk, return and product valuation.
Over the last few years, structured products have carved a
definite niche in most high networth individuals’ (HNI) portfolios.
According to Gaurav Arora, vice-president (products), India
Infoline Ltd, “In the last couple of years, on average there have been annual
issuance of roughly Rs. 3,000 crore and the demand continues to remain
healthy.” What makes these products a popular choice among HNIs is the
combination of yield, principal protection and participation in returns. Says
Rajesh Saluja, chief executive officer, ASK Wealth Advisors Pvt. Ltd,
“Participation in equity returns without risk of capital erosion, make these
products attractive.”
Structured products are rightly positioned for the sophisticated
investor as the nuances involved are many and you need to give it adequate
thought and analyse the details before investing. Here’s how the recently
issued guidelines will help the investors understand the products better.
What’s under regulation
Though a majority of the structures offer capital or
principal protection, there are some that do not protect the principal and
therefore assume the risk of investing in equity. The recent Sebi guidelines
apply only to capital-protected structures.
However, this does not mean that capital protection
structures do not invest in equities: the larger chunk of funds collected in
these is invested in fixed-income instruments and the rest in derivatives where
the underlying asset is the main return generator. Usually, these derivatives
are equity, but some structures also use gold derivatives.
Given that the main payout for structures is a coupon or
interest rate, they are classified as non-convertible debentures (NCDs).
Subscription size
Among other things, Sebi has mandated the minimum ticket
size for subscription at Rs. 10 lakh for any issue. This will act as a
deterrent for small investors, which is good, since these are complicated
products best positioned for investors who can take on all the underlying risks.
Says Saluja, “We assess the net worth and existing
allocation to structures before recommending these products to HNIs. The
minimum ticket size is Rs. 50 lakh, which is compromised only if there are
liquidity constraints that the client faces, but the client profile has to be
right.”
Additionally, Sebi has prescribed a number of disclosure
requirements pertaining to valuation, risks, returns and distributor
commissions with the intent to ensure that the investor is better informed.
The risks
Let’s understand some of the main underlying risks that come
with investing in structured products and the guidelines around them.
Credit risk: The primary and most critical risk linked to
structured products is credit risk or the risk that the issuer may default. The
product, basically an NCD, is issued by non-banking financial companies (NBFCs)
and the adviser is simply a distributor. It is, thus, rated as a debt
instrument from that NBFC and carries the same risk of default and non-payment
of coupon as would other debt instruments issued by the NBFC. This essentially
means you take the risk, irrespective of it being a capital-protected
structure, that the issuer may not be able to pay you back.
Sebi has mandated that credit risk of the issuer should be
explicitly mentioned in the offer document of the product. This is already
being followed in practice by large advisers.
While such default hasn’t yet been witnessed in India,
during the 2008 global financial crisis, there were large overseas issuers
which did default. Says Rajesh Iyer, executive vice-president and head
(products and research), Kotak Mahindra Bank Ltd, “For structured products,
credit rating is a guideline to assess the ability of the NBFC. But risks
remain, as a second check, the adviser and investor should assess the stability
of the underlying asset exposure for the NBFC issuing the debenture.”
Market risk: The asset risk mainly comes from the derivative
part of the product. Here it’s important to understand that each structure is
designed to cater to a specific view on the price movement of the underlying
asset. For example, if the underlying asset is the Nifty, a 36-month structure
may be designed to cater to the analysis that the Nifty most likely will return
up to 5% during the tenor, another structure may be designed to cater to the
view that the Nifty will double the returns over the same period. Participation
rate, coupon, knock out and other relevant features (see box) vary according to
the view taken.
Before you subscribe to a particular structure, you need to
have a rough idea of where you think the Nifty level will reach at the end of
the tenor. This will determine the final payout you are willing to accept from
the adviser. This is very unlike investing in mutual funds, debt or equity, or
even fundamental stock picking. If your view is wrong, you risk not making any
returns from this product even after being invested for two-three years or
more.
Says Iyer, “For larger ticket sizes, there is a
customization of the structure based on the client’s view of where the market
is headed. Typically, though it’s a merging of the house view (portfolio
manager) with the client’s view. There are mass products, which subscribe to
the general trend, as well.”
Event risk: Unexpected events such as natural calamities,
civil wars, terrorist attacks and technology crash can lead to a standstill in
asset trading. While the probability of such events happening is very low, but
they have happened and a halt in trading can impact not only the value of a
derivative but also the fixed income portion of the structure. The occurrence
and outcome of such events is hard to predict, thus this can’t be quantified or
avoided.
To help investors understand this risk better, Sebi has
mandated disclosure of model risk, which essentially says that the actual
behaviour of securities may significantly differ from what the mathematical
model says as it will be influenced by market events.
Is it worth the risk?
Says Iyer, “For capital protected structures, we allocate
10-15% of the client’s fixed-income money and aim not to have more than 20% of
the overall portfolio in structured products.” According to Saluja, these
products warrant roughly 5% allocation within the asset class—fixed income or
equity—they belong to.
Despite the risks, this product has a unique proposition
which allows you to make money regardless of the volatility in asset prices.
Moreover, even if the underlying asset is in a rally, the participation rate of
more than 100% means that you make more returns than if you invest directly in
the underlying asset.
Structures which offer a fixed coupon (dependent on the
level of underlying asset at the end of the tenor) are also very attractive as
the payoff is certain and that makes sense in volatile markets. Moreover, structures
with capital protection mean that there is no downside in the product itself.
Says Rohit Bhuta, chief executive officer, Religare Macquarie Private Wealth,
“It’s not a product that every client demands. It’s more like a solution for
sophisticated investors and surely has a small place in their portfolios.”
Of course, you have to remember the biggest risk you
undertake is that the issuer may default and in that case despite the capital
protected nature of the product, you may not get back the principal.
Also, these are event-based products and the view prescribed
has to be accurate for the product to deliver. Adds Saluja, “Globally, 70-80%
of structured products don’t deliver, but when they do, for capital protected
structures which form part of fixed income, returns are hugely enhanced and
that’s a chance people are willing to take.”
How do you choose?
The confusion arises in deciding which kind of structure
suits you the best. Firstly, you have to have some idea about which direction
you think the underlying asset prices are headed. A product may be geared to
take advantage of a 15% rise in the Nifty after three years, whereas you are
actually expecting at least a 30% rise; in this case, you may not make any
money if there is a knock out when the Nifty rises by 20%.
Also, small changes in one feature of the structure may make
it look better than another, but that may not be the case. For example, a
product that offers a participation of 200% isn’t necessarily better than a
product that offers a participation of 150%. You have to consider other
features such as credit rating, knock out, coupon and tenor. In all likelihood,
if one feature looks more advantageous, then another may be restrictive.
Moreover, as Arora says, “You have to avoid overexposure to one issuer.”
In an attempt to standardize reporting of returns, Sebi
guidelines talk about indicative returns/interest rates being shown only on
annualized basis. So far, portfolio managers have been disclosing absolute
return/interest figures along with the compounded annual growth rate over the
life of the product or the annual interest rate, as the case may be.
Other guidelines
Valuation: Some guidelines such as appointment of a
third-party valuation agency will add to the issuer’s cost. The valuation is to
be done by a Sebi-registered credit rating agency and published at least once a
week. Expertise of credit rating agencies in analysing and valuing structures
is nascent and streamlining this will take time. However, it is a step in the
right direction though challenges remain.
Frequently valuing these hold-to-maturity products may not
be most productive and accurate given the many variables involved. Says Iyer,
“For these products, the market is illiquid, so valuations may look skewed.
Also, for debt securities there is a marked-to-market value and that can make
the valuation a bit hazardous.” The implementation and appropriateness of the
valuation disclosures are still a grey area.
Commissions: Sebi has mandated that the broker commissions
be disclosed to the client. The norm so far is to disclose fees in the
information mandate. Says Bhuta, “These guidelines attempt to minimize conflict
from the client’s perspective and ensure that they can question the distributor
about the fees charged.” At present, in some cases, where the distributor and
manufacturer are under a single umbrella, there could be hidden fees.
The guidelines are a good move in transparency. Says Arora,
“The present scenario analysis showed to clients is already ahead of what Sebi
is talking about.” It is also important to remember that the very nature of
structures is customization and to that extent, standardizing return and
valuation disclosures may have the undesired outcome of creating more confusion
than intended.
Glossary
Here are some common features of a structure. These get
tweaked for customization of each structure, which may have unique nuances.
Also, it is not necessary that each structure has all these features.
Coupon: While all structures may not have an in-built coupon
or interest rate, some have a specific interest payout if certain events
(market linked) occur. This is specified in the product brochure.
Participation: This is the amount of return you can generate
from the derivative part of the product. It basically refers to the
participation in returns of the underlying asset. For example, if the
underlying asset is an equity market index such as the S&P Nifty, then a
participation of 120% means 120% of the returns generated by the index in a
specified time period.
Knock out: This is the upper price limit of the underlying
asset beyond which the contract gets “knocked out” or ends at a value much
before the completion of its tenor.
Rebate: The return earned if the structure gets knocked out.
Tenor: It is usually specified with two time lines. For
example, the tenor for a three-year structure may be specified as 36/39— here
36 refers to the number of months in the tenor and 39 refers to the month of
the closure of the product. In the three months between the end of tenor and
closure, the product can be listed on an exchange and sold in the secondary
market.
Initial level: This is the level of the underlying asset on
the start date of the product. It is better if this is specified as an average
rather than a one-day price.
Final level: This is the level of the underlying asset when
the structure ends. Similar to the initial level, it is better if this is
specified as an average. For example, for a Nifty-linked structure, the final
level can be the three-month daily price average taken in the last three months
of the tenor. By doing this, market risk is mitigated to an extent.
Strike level: This is a specific observation level of the
underlying asset. For example, strike level can be 80% of the initial level or
20% below the initial level. In some structures, the final payout is linked to
the strike level rather than the initial level.
Auto call level: It’s a specific level of the underlying
asset. If reached, the product gets auto-called or closed. There can be a
defined payout if the auto-call level is reached. For example, the auto-call
level can be 105% of the initial level, which means if the Nifty gains 5%
anytime during the tenor of the product, then the payout will be fixed as
defined.
Source: http://www.livemint.com/2011/10/16210216/Sebi-aids-structured-product-i.html?h=B
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