Spike in long-dated products as issuers try to keep principal protection attractive, analyst says

By Kenneth Lim

Boston, March 13 - Issuers who want to meet the demand for principal protection amid low interest rates and high market volatility are pushing out maturities in order to offer attractive terms, structured products analyst Tim Mortimer of Future Value Consultants said.

"That's about the more common method," he said.

Future Value has published research notes on seven principal-protected structured notes in March so far, compared with just one or two per month in the previous four months, Mortimer noted.

The latest report analyzed Royal Bank of Canada's zero-coupon principal-protected notes due March 31, 2015 linked to the S&P 500 index.

At maturity, investors will receive par plus any gain in the index, subject to a maximum total payout of 150% of the principal. Investors will receive at least par.

The product received an overall score of 7.58 out of a best possible 10 from Future Values, while its risk profile was a relatively safe 1.31 out of a riskiest 10.

"The product scores low on the riskmap rating which reflects the principal return feature of the product," Future Values wrote in the research note. "This investment would therefore likely appeal to cautious investors seeking a known minimum return at the end of the investment term."

Spike in maturities

Although the vast majority of structured products in the United States have maturities of fewer than five years, longer-dated structures are the norm across the Atlantic, Mortimer said.

"In the U.K. five to six years is the average," he said. "In France the average is eight years for tax reasons, and in Scandinavia it's longer dated products as well. Japan is the same as the U.S. where the maturity is usually one to three years."

"I think the U.S. investors come for sort of an active trading portfolio or investment approach," he added. "You can kind of have a trading view of something for the next 12 to 24 months, but it's harder to take a trading view for six years. In U.K. and Europe the main objective is to provide principal protection and give equity markets a decent chance to increase."

The recent spike in the United States is probably due to market conditions, Mortimer said.

"I guess there's two reasons that may have prompted the issuance of this product by RBC," he said. "One is they may have seen stronger investor appetite for this. Successive bear markets may wake people up to the idea that giving equity markets more time may be a good idea."

"Also, with interest rates so low and volatility so high, no doubt RBC has seen appetite for principal-protected products, but trying to issue a short-dated principal-protected product is very hard," Mortimer said.

Because interest rates are low currently and options are expensive, issuers who want to price principal-protected products cannot offer as attractive terms as in more favorable market conditions, he said.

"But by pushing it out to six years, you have something that's reasonable," he said.

Different risk

Investors, however, might be wary of locking themselves into products that are too long-dated because of current concerns about the stability of the issuers, Mortimer said.

"Something that's perhaps hindering the use of longer maturities is...if you're buying a six-year note and intending to hold it for six years to maturity, you'll be holding the credit risk of one institution for six years," he said.

Figuring out how much an issuer compensates the investor for the issuer's credit risk requires breaking up the product and valuing the options, and that can be complicated, Mortimer said. But in general, he has noticed that investors do get some compensation for taking that risk.

"You get better terms from the worst credits," he said.

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