Structured notes Podcast

Structured notes: Their returns are not too good to be true and why it is important to pick the right bank – Wealth Migrate and deal partner Cashbox Global

Just before the credit crunch in 2009, Wall Street brokerage firms and stockbrokers aggressively marketed what appeared to be safe and conservative Lehman Brothers structured notes and we all know how that turned out. The big losses that investors suffered and the ripple effect it had across the world have led to some investors steering well clear of these securities. Wealth Migrate and their deal partner, Cashbox Global, however, feel that structured notes have evolved substantially since then. Scott Picken, the CEO of Wealth Migrate, told BizNews that structured notes meant that retail investors could invest like the ultra-wealthy, while Riaan van der Vyver from the Global Wealth Group highlighted the benefits of predefined outcomes. Cashbox Global head of product structuring, Andrew Mobsby told BizNews that it is important for investors to pick a structured note supplier with a robust track record. – Linda van Tilburg

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Returns are not too good to be true

Predefined terms and outcome: structured notes are not that complicated– Riaan van der Vyver
Structured notes, in essence, are not that complicated. There are two components to a structured note. First of all, it’s typically issued by a bank like, let’s say, BNP Paribas, BBVA and so on. So, the two components of the structure consist of one bet. In other words, you are borrowing money, in essence, from the banks so that you can get your money back and then a derivative component. Why is it a derivative component? Very simply, a structured note has a reference basket which derives the returns. So, you don’t own the reference basket, but the returns on the structure notes are derived from the price movements after the reference basket, hence a derivative: the combination between debt and a derivative. That’s why structured notes are so popular, there’s what we call a predefined shape or pay-off profile. Simply what it means is, there’s preferred terms, so an investor knows what to expect from a structured note given that a set of circumstances are met. For example, if the price of the reference basket doesn’t fall by more than 25%, you will get your income or if the price of the basket doesn’t fall by more than 50%, you will get your capital back. So, you can see there are predefined terms and outcomes

Why 12% returns are not only for the ultra-wealthy – Scott Picken
The problem with all of us is that we deal at a retail banking level, which means we’re getting like a retail return, call it what we all use to 5.6 or 7%. Then we have a wholesale rate that is sort of 9 – 10%. But then you got institutional rates and that can be 12% plus. And I was like, what? People are actually earning in hard currency, US dollars, pounds… more than 12%. And they said yes, it’s institutional and what you can do with fractionalisation – so in those days the minimum investment was $2 million, which is why only ultra-high net worths knew about it –  you can fractionalise it and people can get access. They can outdo the retail and wholesale and go straight to institutional. Really, when I understood that it made sense to complement the real estate assets with people being able to get the returns. This is actually a really respected instrument in the high-net-worth space. What I found fascinating was when I asked our top 100 investors, would you be interested in structured notes? I was expecting quite a lot of rhetoric around, no, they don’t like it or it’s a Ponzi scheme or whatever; they don’t understand it. But more than 80% were really invested in structured notes, and that was a massive learning lesson for me because the people that are dealing at the top of the market are already in structured notes and therefore all of us should be looking at them.

But how do you avoid another Lehman Brother situation? – Andrew Mobsby
That’s probably one of the key questions I always address when I’m talking to a client or talking to anybody about what a structured note is. Essentially the bank, the issuing bank, the investment bank that issues this product, it’s a debt issuance product; so, it has to come off the balance sheet of that bank. In other words, the bank has to be in a position to tick those boxes to say, our credit committee, our investment committee, our shareholders. It’s coming off our P&L. So, we better make sure that this is going to be a win-win situation for the bank as well as for the investor. With that in mind, I mentioned the evolution of structured notes, and I think what one needs to be very aware of is to deal with the right type of issuing bank. So, in other words, Cashbox, for example, will not look at an issuance out of any bank that is not a Tier One international bank with an A rating. In other words, A-ratings would come from your typical credit rating agencies like Fitch, Moody’s, S&P, and sure, they can get it wrong. Obviously, they are not fail-safe, but it gives you a great level of comfort to know that you’re dealing with household name banks in the world. True global banks that have a great deal of pedigree, great deal of history or experience in these types of issuances. So, dealing with your bank is probably your biggest counterparty risk in issuance.  If something happens to your bank, if that bank is not around tomorrow, if you’re dealing with, let’s say a triple C minus bank or something like that or somewhere in the world that bank might not be around in terms of the terms and conditions that it has to fulfill – it has to be out of the top drawer.

Pre-defined outcomes that proved to be a good bet before the Russian invasion  – Van der Vyver
Just to illustrate the importance of these terms and conditions, in other words a predefined outcome. Two days before the Russian invasion, with Cashbox we launched a structured note, issued by BNP Paribas. The underlying basket consisted of technology enabled stocks at 18% return per annum. So, suddenly with this heightened uncertainty, volatility and so on, the structured note  brought a higher-than-normal bank product yield, but it brought certainty in this period of volatility and that is one of the biggest attributes of a structured note. You know what you’re going to get, which means an increased chance that investors can meet their objectives, which is so important as part of financial planning.

Are the returns too good to be true? – Andrew Mobsby
Investment banks are not charities. They do things for a reason, and there needs to be a win-win situation to keep it as positive for both the banks plus the capital, because obviously at 15% or 20%, that’s a high cost of capital that we are lending our money at, and they will have a payoff profile. So, a lot of work goes into the back-testing and the algorithmic models that make up these coupon pay-offs. If the bank is not paying generously. It’s doing it for a very specific reason – to raise a tranche of funds that they are looking to hedge an issuance of options that they want to actually own at a point in time. So, just to give you a fresh look  on it – the bank is obviously going to be paying out money if it’s an income product upfront – if it is a growth product the payments will be at maturity, but by the same token, there’s going to come a point in the timeline of the product where the bank is going to be sitting with those underlying investments for itself that it can on sell again so it makes money again. Certainly they will have factored in in terms of what the real cost of the money is. Banks look to attract money all the time – they need liquidity, especially investment banks. But as I said, it always has to pass muster. It has to pass muster at the credit committee and the investment committee. There has to be a longer game than simply dealing with the structure note. The structured note is one part of the deal we’re involved in, in terms of getting a great product off to the investment community globally, but certainly the investment banks would thereafter have a secondary trade on those options later on. Typically, an investment bank will turn the coin many times to recover and make money on the product.

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