As every investment manager will tell you, we are living in stormy and uncertain times. But there are some good investment opportunities, especially coming from the recent turmoil in the markets and the huge mispricing of different assets.

This current situation has put the financial community, and in particular investment advisors in a difficult situation. Should they profit from the mispricing existing in the majority of assets or should they remain holding cash? A natural answer to this question is the manufacture and distribution of structured products, where you can have the advantage of an exposure to different assets but profit only from the upside while your capital is protected or guaranteed. Put this way, it looks as if structured products are the perfect tool for these times…but questions still need to be asked.

First of all we have to bear in mind what a structured product is. It is basically a mix of a zero coupon bond and an option. You have two different instruments packaged together and you can forget about it until the market moves in your favour or the product matures. But, wait…

• - You said a zero coupon bond?
• - Yes
• - And this zero coupon is a gilt or a treasury or some kind of government instrument?
• - No
• - Well what is it then?
• - it is an IOU that we are giving you in a bond format issued by ourselves
• - By yourselves?
• - Yes, we are a strong financial house, which has never defaulted.

After this hypothetical discussion we can examine the first question. Who is guaranteeing the capital of the investment?

Once this point is clear, and it is a very important question when choosing a structured product, you should be able to measure the risk. Of course you have different risk measurements, the most traditional ones are provided by rating agencies, but they are not always the best.

Rating Agencies

Rating agencies could be good at assessing the risk of some types of sovereign debt, where the macroeconomic data is easily available, but even in these cases the strong implications that a downgrade has in public finances causes them to act very slowly and only where the symptoms of the disease have already been fully accepted by the market. Usually when there is a downgrade it is generally too late to take any investment decision and you are forced to assume your capital losses. If this is the case, where can we look for a more precise and timely indication of risk of default? The answer lies in the market itself.

The CDS as a perception of risk by market participants

CDS stands for “Credit Default Swaps” which is basically an insurance against credit risk. Different issuers or institutions will have different CDS levels according to the perceived risk, in the same way that different drivers will have different premium insurance quotes. A high CDS will mean that the market is asking for a high premium in order to give you an insurance against the probability of default of a given institution, plc or company. Most issuers will have a positive CDS, meaning that they have higher risk than a bond issued in the same currency by the Treasury (although in some special circumstances this is not the case). As the CDS level is derived from the perception of risk that the market has on a particular debt issuer it has a very strong bearing on its cost of funds – where there is more risk more interest is demanded (does anyone remember any Icelandic Bank with high and competitive interest rates?).

Advantages of a CDS

The CDS market is an open market and is not regulated where contracts are private and bilateral. It trades as long as there is any market participant wanting to quote a bid or an offer, and it’s liquid enough to trade huge volumes without altering the prices.

And why are people not using it as a measure for their products?

In the table below you can see how different providers have different risk levels defined by their CDS levels. Basically you have to follow the rule (see figure 1).

The transparency provided by CDS gives you a very good idea of the risk you are bearing. In the same way it will show why different providers could offer much better terms and here we arrive at the Gordian knot of risk reward ratio. This higher coupon or return offered sometimes by some providers is not always linked to a better manufacturing process or to an excess of wisdom, but basically we are back at the case of the Icelandic Banks; if your funding costs are higher you will be able to offer a higher rate in your deposits, it’s as simple as that.

How should this information be factored into asset allocation decisions, taking into account the risk profile of the client?

We have established that structured products offer varying levels of risk according to the rating and CDS level of the issuer. Hence, when an adviser undertakes the task of allocating different weightings to the various asset classes that they are considering for a particular client they need to ensure that they apply the correct weighting to structured products according to the risk of the issuer. It follows that a client with a conservative risk profile will have a much higher weighting in structured products whose issuer has an AA rating with a low CDS spread.

The FSA will surely start looking into asset allocation decisions made by IFAs in the future and scrutinise them to see how those investment decisions were made. It is therefore advisable for IFAs to start using this risk adjusted returns methodology when taking asset allocation decisions for their own clients, not only to ensure that they have done the correct analysis but also in order to ensure that these recommendations don’t come back to bite them at a later date.

CDS levels for the main providers in the UK