Opt for structured products amid high interest rate, volatility

By Vinay Ahuja, Senior Managing Partner, IIFL Wealth Management

Defined benchmark returns, capital protection, known maturity dates and a favorable taxation regime are the top four reasons why high net worth individuals (HNIs) are increasingly choosing to invest in structured products.

Structures products typically give capital guarantee at the end of the tenor and a higher participation. From a taxation perspective, structured products are taxed similar to equity mutual funds and have lean as well as transparent fee structures which come with no embedded costs.

The volatile and unpredictable nature of stock markets has created a pressing need for products that can not only weather the maelstrom of the markets but also thrive in it. Through structured products, investors not only have the option of preventing their investment from eroding in stagnant or falling markets, but also to generate positive returns through that phase. Most structured products can be designed in such a way that they are able to protect capital and generate positive returns across a variety of market situations.

Simply put, a structured product is a hybrid investment instrument that helps improve the return on a fixed income instrument while at the same time protects the downside through derivatives. Derivatives give it the flexibility needed to blend with a portfolio and enhance its risk to return performance while matching an investor's objectives.

Let's understand with an example.

An investor has Rs 100 for investing in a combination of equity and debt for three years. How can a structured product help protect capital as well as generate equity linked returns?

Capital protection

Assuming a simple interest rate of 9.5%, if you invest Rs 76 in a good rated bond, it will grow to Rs 100 in three years. This ensures capital protection.

Investment for alpha

The balance Rs 23 can be invested in the Nifty 50 at-the-money call options.

Scenario I: If the Nifty gives a 50% return in three years, Rs 23 will become Rs 50.

Maturity Value will be: Rs 100 (from NCDs) + Rs 50 (from Nifty 50 call option) = Rs 150

Scenario II: If the Nifty falls by 50%, Rs 23 will become Rs 0.

Maturity Value will be: Rs 100 (from NCDs) + Rs 0 (from Nifty 50 call option) = Rs. 100

In both cases, the investor's initial capital was protected while in one case he was able to reap returns.

A rising interest rate environment peppered with volatility is well suited for structured products. In such an environment, one requires lesser money for capital guarantee as interest rates are higher. For example, at 10% interest rates, one would need to set aside Rs 77 for three years to get Rs 100 at maturity. However, at a higher interest rate say 15%, one would need to set aside only Rs 65 for three years to get Rs 100 at maturity. Consequently, while in case of the former only Rs 23 is available for equity investment, in case of the latter, Rs 35 is available for equity investment in options.

The significant appeal of a structured product is its defined returns. Even if a structured product only returns the invested capital at maturity, this outcome is welcome in adverse market conditions, as against losing money.

The risks

Issuer risk: The biggest risk in structured products is that of issuer default. It is for that very reason that managers creating structured products should do an extensive due diligence on the issuer, looking at past and present payment obligations as well as NPAs, if any. The fund manager should only invest in well rated bonds of those companies which he believes will definitely pay at the end of the tenure.

Liquidity risk: While structured products can be listed on exchanges, they are not actively traded. Thus, it might be difficult for investors to exit their investment before the maturity date.

Rigid: structured products have rigid pre-set dates and to that extent are not flexible. Investors need to be aware of this before they commit their funds to structured products.

Investors should invest in a diverse set of assets and products that can both generate good returns as well as protect the portfolio in volatile market conditions. HNIs looking to diversify their portfolios should consider allocating a portion of their equity portfolio to structured products.

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