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).
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.
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.
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.
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.