Capital Protection in Uncertain Markets

The salient points of capital protection investments are highlighted in this article.

Irecently chatted with a (fairly) sophisticated friend about wealth preservation and was dumbstruck by how he had misunderstood many of today’s popular investments. He was always most up to date about the latest technology, fashion and gossip. In my book, he had held an AAA rating but this was downgraded to BBB after our disappointing discussion.

We agreed on how bankers and brokers pride themselves on giving customers what they ask for. Many listen carefully to the needs, desires and fears expressed by investors. The market intelligence is then used to mobilise resources to deliver would-be-in-demand financial products and services. As investors feel that equity markets are volatile and fraught with risks, the response is to provide capital protected investments. Even hedge funds, previously reserved for the sophisticated, high net-worth investor, are now distributed in bite-size units to satisfy retail demands. Also popular are yield enhancement products in today’s low interest rate environment. So far, my friend and I were in agreement.

To my friend, investments that feature ‘capital protection’ meant ‘conservative’ and ‘safe’ investments. But is this necessarily true of all capital protected investment products? All apples may start out ‘green’ but are all apples ‘green’ in colour? The capital protection feature is structured more or less the same way. Risks specific to different structures are what differentiate their level of safety. Let us examine what this means.

A capital protected structure mainly consists of a fixed income component that generates a return sufficient to repay the investor a fixed sum at maturity. This fixed amount is normally the invested capital. For example, an investor puts US$500,000 into a six-month capital protected investment:

let’s say that the Bank places US$496,775 on time deposit at 1.3%pa for six months;
after six months, the time deposit generates US$3,229 of interest;
principal + interest of the deposit amount to US$500,004 at maturity; and
the US$500,000 invested capital can conceivably be returned intact to the investor.

What’s more interesting is how the bank manages the discounted figure (US$3,225). This is normally pooled with the discounted interests from other investors of the same capital protected investment. How this pool of money is then invested depends on the structure of the capital protected investment. If it has, for example, an equity theme, then the investment could be on a single equity, a basket of equities, equity indices or specially selected equity mutual funds. However, the investment need not have anything to do with equities at all. The theme can be focused on interest rate movement, commodity prices, specific hedge fund strategies, volatility of foreign exchange rates or the performance of an investment fund, to name a few. This pooled investment is invariably leveraged with the use of derivative instruments. Here’s how it could work:

Let’s say that the discounted US$3,225 is pooled and invested in financial options on the foreign exchange rate movement of EUR/USD over the next six months.
If the EUR/USD exchange rate does not move outside a pre-defined price range, then the options would pay three times US$3,225 or US$9,675.
If at anytime during the six months, the EUR/USD exchange rate moves outside the specified range, then the options would pay nothing.
Let’s assume that the market was favourable to the strategy of this structure. The investor would receive US$9,675 + his invested capital of US$500,000 after six months.
This translates to an investment return of 3.87%pa, which is substantially higher than the current six-month time deposit interest rate.

The above explanation was nothing new to my friend. Where my friend and I differed was in our appreciation of the risks in context of the current investment environment.

In a higher interest rate environment, there would be more discounted interest potentially available for investing in derivative instrument(s). Given a higher discounted interest, such investment structures can even offer capital protection plus a guaranteed minimum return. This is achieved by deploying less of the potentially available discounted interest on derivatives. How about the low interest rate environment of today?

The market currently offers higher interest rates for three years than six months and higher rates for 10 years than three years. By extending the investment period of the capital protected investment, there can be more discounted interest available up front. In today’s environment, banks are offering capital protected investments for as long as seven or 10 years.
There is usually no capital protection for early redemption. Prior to maturity, the interest-yielding part of the structure is unlikely to achieve a return sufficient to cover the discounted interest used to purchase the derivatives. By extending the investment period to seven or 10 years, capital protection may only be available to the investor at the end of seven or 10 long years. As no financial investment is foolproof, the investment can potentially lock up one’s capital for nothing.
Safety comes at a premium. Less creditworthy governments, quasi-governments and corporations, therefore, offer higher yields for their debt (some are classified junk papers/bonds). By investing the interest-yielding part of the capital protected structure in less secure, fixed income instruments, there can be more discounted interest available. One may be tempted to create capital protected investments with less secure components.
By sacrificing security for higher interest offered by less creditworthy instruments, the worst-case scenario is bankruptcy of such borrowers. This may result in a total loss of the interest-yielding portion of the investment structure. As this portion accounts for the most part of a capital protected investment, the loss of invested capital can be substantial. Investors should, therefore, scrutinise the terms and conditions to determine ‘who’ is backing the capital protection. Is it the bank or broker offering the product as agent? Is it the issuer of the product? Is capital protection only implied by the type of investment structure but not actually guaranteed?
To maximise the little discounted interest available, one may be tempted to use less expensive derivatives, which are usually riskier in nature. The riskier a derivative strategy, the lesser the likelihood of success. With the help of an investment professional, one may better understand the risk/benefit analysis.
Capital protected investment products are not trading instruments and many do not have a secondary market for early redemption. They are best held to maturity especially if the underlying strategy is working in one’s favour. When investors see the product working in their favour, they are sometimes tempted to take profit by redeeming the investment prior to maturity. This may result in frustration because of how the derivative instruments imbedded in such structures behave over time.

My friend who did not fully understand such investment products had demanded of his banker to deliver rather aggressive structures out of ignorance. A capital protected investment that is not put together prudently to maximise benefits for the investor can produce unwanted results.

With the low deposit interest rates today, there is perhaps less risk than a few years ago. Given a well-structured investment strategy that does not entail a long investment period and has capital protection guaranteed by a financial institution acceptable to the investor, there is clearly a place for capital protected products in any investment portfolio. It’s worthwhile to discuss the investment formula of potential capital protected structures with an investment professional and learn the genuine benefits from capital protection in today’s uncertain financial markets.

Markus Mueller
UBS Private Banking