Structured products made simple
In a bid to make the popular but complicated structured products more lucid for investors, the Securities and Exchange Board of India (Sebi), last month issued guidelines on additional disclosures for their issue and listing. Lisa Pallavi Barbora reports.india Updated: Oct 21, 2011 22:32 IST
In a bid to make the popular but complicated structured products more lucid for investors, the Securities and Exchange Board of India (Sebi), last month issued guidelines on additional disclosures for their issue and listing. 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.
Over the last few years, structured products have carved a definite niche in porfolios of most high networth individuals' (HNIs). The combination of yield, principal protection and participation in returns make these a popular choice among HNIs.
"In the last couple of years, there have been annual issuance of roughly Rs 3,000 crore and the demand continues to remain healthy," said Gaurav Arora, vice-president, products, India Infoline.
Here's how the issued guidelines on structured products will aid investors.
What Is under regulation?
The larger chunk of funds collected in structured products 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).
Sebi has mandated the minimum ticket size for subscription at R10 lakh for any issue. This will act as a deterrent for small investors, which is good, since these are products best positioned for investors who can take on all the underlying risks.
Additionally, Sebi has also prescribed a number of disclosure requirements pertaining to valuation, risks, returns and distributor commissions, to make the investor better informed.
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 other debt instruments. 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.
While such default hasn't yet been witnessed in India, during the 2008 global financial crisis, there were large overseas issuers which did default.
Market risk: The asset risk comes from the derivative part of the product. Each structure is designed to cater to a specific view on the price movement of the underlying asset. 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. Participation rate, coupon and other relevant features vary accordingly.
Before you subscribe to a particular structure, you need to have an 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.
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. Though the occurrence and outcome of such events is hard to predict, 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?
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 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. "It's like a solution for sophisticated investors and surely has a small place in their portfolios," said Rohit Bhuta, CEO, Religare Macquarie Private Wealth
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.
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.
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.
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.