Josh Mayne, structured product technician at StructuredProductReview.com, discusses the recent re-entry of capital protected structured products into the market, why they do not 100% protect capital and how they differ to structured deposits.
Though capital protected structured products have been few and far between in the sector over the previous decade, IDAD has recently released its latest capital ‘protected’ plan, which along with a steady increase in issuance of structured deposits, has duly prompted us to dispel an all-too-common misconception which occurs between the two plan types.
The key similarity between deposit based and capital ‘protected’ plans is that they each protect investors’ capital from downside market risk.
A typical capital-at-risk plan will protect investors original capital against a fall in the underlying index up to a certain point – deposit based, and capital ‘protected’ plans will return the original capital in full regardless of the extent of the fall in the underlying.
However, where they fundamentally differ is in relation to counterparty risk, which shouldn’t be overlooked by investors. This risk refers to the potential that the issuing financial institution might default on its contractual obligation.
The Financial Services Compensation Scheme (FSCS) provides a layer of protection for depositors, protecting up to £85,000 per bank, per individual. This protection extends to include structured deposits which, to an extent, provide investors with protection against the counterparty bank failing.
A capital protected plan is not however a deposit but simply an unsecured note issued by the counterparty where the terms oblige the issuer to return the investment in full at maturity. As such, the risk of default is an inherent risk for which a potential reward is being paid and if that risk manifests into a loss because of default, it is not a loss that would qualify for FSCS cover.
As such, despite their name, capital ‘protected’ plans do not provide protection in the event of an issuing counterparty defaulting, under which circumstance the return of capital would be subject to insolvency proceedings.
Following the risk return trade off, investors should expect to be better rewarded the more risk they take and as such, a capital ‘protected’ plan should offer some enhanced return compared to an otherwise equivalent deposit-based plan.
