Principal protection

There are two main ways a structured note seller can engineer a product in order to protect principal. The first is the traditional structured note format of taking the investor’s money, using some of it to buy a zero-coupon bond (which costs less than par and rises in value to par at maturity) and using what is left to buy options to give exposure to whichever asset class the investor is keen on. So a classic structured note, for example, would combine a zero-coupon bond plus a call option on an equity index.

The other method is constant proportion portfolio insurance (CPPI), or variants thereof. CPPI works by maintaining a balance of assets between a risky portfolio, such as equities, and a riskless portfolio, such as cash. The mix of assets is managed dynamically, with the underlying portfolios rebalanced to maintain a minimum safety net depending on the movements of the underlying risky asset prices. The idea is to give optimum exposure to the relatively high-return market while maintaining capital protection.

The difficulty with early forms of CPPI products was the possibility that investors could end up being cash locked when there is a dramatic increase in equity market volatility, so the investor could end up with 100% exposure to cash until the note matures. In the last few years, however, new forms of CPPI have emerged from the banking sector that are designed to avoid leaving the investor completely locked in to low-yielding assets. These are referred to as dynamic forms of CPPI. With these products any interest earned on the safe portfolio increases the "cushion" – the difference between net asset value of the overall investment and the present value of the capital guarantee – level, which then supports increased risky asset exposure. The investor therefore has the chance to slowly recover from a position of having little or no risky asset exposure.CPPI products, depending on how they are structured, will have deleveraged in response to the increase in equity market volatility. But the question is by how much. Are there investors out there who are now cash-locked? The consensus seems to be that the volatility was not so extreme that investors have ended up cash-locked, or near cash-locked. "In Europe, there isn’t a single equity-linked CPPI product that we’ve done that has become cash-locked. Several of them did deleverage, but many of them have tended to leverage up again as markets have recovered," says Citi’s Jean-Luc Bernardi.

"In the high-net-worth segment, people tend to go more for non-principal protected structures than a zero-coupon plus some sort of option," adds Benoit Savaria, Citi’s EMEA head of internal structured sales, equity derivatives and hybrids

And when it comes to pricing zero-coupon bonds, how have rate changes affected the cost of this form of principal protection? "Longer-term swap rates [where zero coupons tend to be priced] are generally more stable than short-term money market rates. They have moved a bit, but given the huge changes we’ve seen in option prices with respect to volatility, it’s a secondary consideration," says Commerzbank’s Donald Leitch.