Structured Products and Guaranteed Products - are they worth the risk?

Posted on: 09 November 2010 by Alexander Hay

Structured products are as transparent as Wayne Rooney's contract negotiations. Unlike most investments, a structured contract operates by investing into complex derivatives alongside buying guarantees through counterparties. are probably bored already, but persevere; these are sold by the bucketload to unsuspecting investors at banks as simple products.

From my conversations with readers, it seems few investors have ever received a proper explanation of counterparty risk. Counterparties are the most important aspect to understand as they provide the capital return at the end of the term of the investment and any default will mean the customer is also not covered via the financial services compensation scheme.

Allow me to reiterate - you would lose all your money. As most structured contract investors are risk averse, how can it be possible that they would be happy to have the risk that all their capital could disappear? One can only assume that the true extent of their risk has not been explained to them.

The FSA now insists that advice on structured investment products should be given in the knowledge that investment grade counterparties can fail. Therefore, financial advisers should be able to explain the potential for risk and the potential for loss on a counterparty. How then can they do that?

This is where it gets tricky. Advisors have few options, but ascertaining the risk rating from Standard and Poors is one, as is seeing what Moody's and Fitch have to say. Also, the adviser should understand the counterparty risk and the implications of that counterparty risk.

Furthermore, an investor should also look at the credit default swap of the company providing the counterparty. A credit default swap is a good method of ascertaining risk and the changing risk. A credit default swap is a measure of the market's pricing of the institutional risk of the provider.

So for example, if the cost of insuring £100 debt of Lloyds was less than £100, they would be classed as a low risk of default. The cost of insuring £100 of Lloyd's debt is actually 177.82 (a 5 year credit default swap, or CDS). (1) Meanwhile, HSBC's CDS at 74.53 tells a rather different story. So the worse your credit default swap, the higher the cost of servicing that debt, but of course the higher the risk to the investor of losing their entire capital too.

Furthermore, a financial adviser should be looking very closely at which direction a credit default swap is moving. For example, the fact Abbey Santander's credit default swap is 136.45 today versus its 83.50 value about 6 months ago will tell you the market has decisively turned against.

Now I know this is remarkably boring, but if an adviser is selling you this as a simple product then you should now be able to see that it is anything but.

However, and this is an important point, you should also know that Investec is often quoted as a counterparty provider yet it does not have an assessable credit default swap or a Standard and Poors rating.

With that in mind, how then are financial advisers able to assess the potential risk of the structured product before an investor falls straight into it, eyes wide shut?

The charges are also an, ahem - fascinating subject. Most products are sold with the 'there is no explicit charge' line, which is true but not really representative of what investors will read into it. They will read it as no charge at all, whereas there really is one and it is hidden in the returns you will or won't receive.

So, if they have offered you 80% of stock market returns, where is the rest going? This is the easiest place for them to hide expensive profitable charges and there is no regulation in place yet to ensure this is made clear to the customer. It is shocking to believe they are allowed to get away with this!

Need Expert Advice? McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by in 2009.

Peter comments regularly in major journals such as the Mail on Sunday, Irish News and Sunday Times and is a weekly columnist for FT Adviser. He has also appeared on Working Lunch and the Today programme. In addition he is an expert on international tax matters for a range of international publications.

Worldwide Financial Planning Ltd are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.

If you have a financial query you would like Worldwide Financial Planning to respond to, call 0845 230 9876 or email [email protected].

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Alexander Hay

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