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'Spread bets on steroids'? Structured product providers hit back

by Rachael Revesz on Apr 12, 2013 at 08:16

'Spread bets on steroids'? Structured product providers hit back

Structured product providers have hit back after Financial Conduct Authority chief executive Martin Wheatley labelled investments at the more exotic end of the spectrum 'almost like spread bets on steroids'.

In a speech at the London School of Economics, Wheatley said the 'buyer beware' concept had limitations, pointing to the sale of complex structured products, some of which involve 'mind-bogglingly complicated financial gambles' as an area where the idea becomes hard to defend.

He mentioned an example of a six-year term plan linked to the performance of three technology stocks. After six years, if the final price of any of the three shares was below 50% of its initial value, the investor suffered capital loss in line with the worst performing company.

‘Is this product a good deal? Frankly, I’m not convinced,’ said Wheatley. ‘But you can see the attraction.’

Jamie Smith (pictured), chairman of the Structured Product Association, labelled Wheatley's language 'inappropriate'.

‘The designers of structured products follow rules on stress testing and forecasting for every product; rules which the Financial Services Authority provided themselves a year ago,’ he said. ‘These were introduced to ensure consistent standards, and to avoid subjective and personal opinions influencing product robustness. For Mr Wheatley to say it doesn’t look like a good deal to him, just because there’s a chance it might go down, doesn’t make sense.’

Alex Robinson, branch manager of EFG Financial Products (Europe) argued that structured products offered choice and competition to the consumer, and that they were created due to client demands for higher income or capital protection.

‘The benefit to the consumer is they are able to access a volatile area [technology stocks] via a product which provides partial capital protection and defined returns, thereby lowering the risk,’ he said.

However, Adrian Neave, managing director of Gilliat Financial Solutions, said Wheatley was right to raise concerns about the sale of overly complex products to ordinary investors.

‘There have been products in the UK which have not done investors a great service and where they have complex pay-offs: [in those cases] there isn’t an issue with them not being made available to the public,’ he said.

42 comments so far. Why not have your say?

Londoner

Apr 12, 2013 at 09:06

Wheatley may have been also thinking of his first-hand experience of dealing with 44,000 ordinary savers who lost their money in Lehman-backed structured products whilst in his previous role in Hong Kong, and of the thousands of UK savers still caught up in the same. In Hong Kong he did a deal with the distributor banks to reimburse most of the affected savers.

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Philip Dodd

Apr 12, 2013 at 09:20

He`s right, of course. Apart from having to factor in the undisclosed croupier`s take, what is the point of gambling on an outcome which omits 75% of the historic growth contributor (dividends)?

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Chris F.

Apr 12, 2013 at 09:21

I think Martin Wheatley was spot on with these comments. Some structureds are very risky but give the impression that they are otherwise.

I have seen quite a few examples of multi share based products that major on how reliable the companies are but neglect to point out (except in the small print) that this means nothing if markets take a downturn, or the sector falls out of favour.

I'm glad he is raising this issue. There is hope for the regulator yet!

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Kathy Booth

Apr 12, 2013 at 09:21

The adviser should know what is under the bonnet of the product they are recommending and make a suitable assessment of the risks involved and the viability of the investment. It is reckless to recommend an investment without doing their own due diligence. It would be a shame if Structured Products suffer the same fate as UCIS - one foul swoop by the regulator. And I am not sure whether the regulator has the knowledge and expertise to assess individual products for approval, there are some dodgy ones out there that have been assessed as suitable by the FSA.

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Thatcher's Gold via mobile

Apr 12, 2013 at 09:21

Yes but the Hong Kong Mini Bonds were not like the products we see here, they were structured notes issued via special purpose vehicles with three layers to them specifically designed to hide the nature of the underlying securities. There was talk of fraud and deviant misspelling by banks.

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Man of Kent

Apr 12, 2013 at 09:30

@ Thatcher's Gold - Quite so. My son's English studies were ruined by the banks' deviant misspelling.

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Bob Donaldson

Apr 12, 2013 at 09:37

He is right on his comments on this type of structure for the ordinary man in the street; any company can fall from grace and quite quickly, Polly Peck, Marconi, Lloyds TSB, even M & S has suffered dreadfully in the past.

However, not all structures are bad and to make sweeping comments without regard to the end user of such investment plans is unjustified.

Many structures are used by competent investment managers not just the retail end investor.

Given that the banks in Cyprus have done a raid on those with monies on deposit and many would have lost money in Icelandic banks had the government not stepped in and possibly likewise in Northern Rock, he should consider his speech more thoughtlyfully.

Every investment even monies on deposit carry risk. If Barclays were to collapse tomorrow how safe would your money be even with the compensation scheme in place. Who could afford to bail it out?

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Thatcher's Gold via mobile

Apr 12, 2013 at 09:38

I must disagree with PD here as his comment is very misleading.

All investments have the same goal, to make a real return above inflation. The bottom line is what you get back for your investment.

If you choose to invest in a fund which buys stocks then you may receive the benefit of dividends but you also take market risk so capital is at risk immediately the value falls below the purchase price. What these type of structured products offer is the ability to invest in stocks that the investor is comfortable with but with a buffer against market risk as the product in question would not place capital at risk unless the worst stock has fallen 50%. The plans also offer returns of around 12%pa if the stocks do not fall. This is a decent return which many fund managers will struggle to match even with dividends.

The point is that they are not for everyone but do offer real value for those who want to diversify the way they get a return on their investment and for those who want a more defined return and more defined risk. It's all about balance.

These products are not difficult to understand and I know many ordinary souls who would be disgusted that the FCA chief feels they would be incapable if understanding them. He should know better.

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Jonathan Kirby

Apr 12, 2013 at 09:41

@ Kathy Booth

But that is one of the problems, you couldn't get the information.

When we used these things in the 90's and very early years of this century even when dealing with reputable companies like L&G they wouldn't tell you who the counter-parties were - just that they had AA ratings or whatever and we all know how much store to put by them.

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Pat Riot

Apr 12, 2013 at 09:43

"Jamie Smith (pictured), chairman of the Structured Product Association,"

or should that be S tructured P roduct I n V entors association?

The product sounds toxic that was described, punters gets filleted and investment bank product designer makes a tidy profit- Jeez- and they wonder why people hate bankers?

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Thatcher's Gold via mobile

Apr 12, 2013 at 09:43

Predictive text is more dangerous than a structured product, clearly I meant MISSELLING!

Bob is right of course, a bank account is no different to a structured product or a bank note really as they are all just a 'promise to pay' issued by a bank.

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Londoner

Apr 12, 2013 at 09:43

The Hong Kong Lehman 'mini-bonds' may have been structured slightly differently, but they had the same vulnerabilty as other Lehman-backed structured products (ie. that the money had been invested in Lehman-issued loan notes) and the same mis-selling issue (the products were targeted at risk averse savers without explaining the risks). The problem was of course far wider than Hong Kong. Other countries hit by Lehman-backed structured products include Germany (60,000 savers), Taiwan (50,000), Belgium (18,000), Spain (15,000), Singapore (11,000) and UK (8,000).

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Bob Donaldson

Apr 12, 2013 at 09:58

@Londoner - It was probably the selling of the products that was the issue not the product in itself. Again probaly not suitable for all retail investors but there are some highly sophisticated investors out there who should not be denied such products.

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Thatcher's Gold via mobile

Apr 12, 2013 at 09:59

You've hit the nail on the head.... Misselling. If the client is advised of the risks and they are consistent with his or her risk profile and capacity for loss and there is complete transparency then there is no problem. Joe public has no problem betting on the Grand National which is a terrible investment for the majority but the do so knowing the risks.

Time we focussed on the quality if advice and good practice. If the advice process is correct then that acts as the risk filter to stop poor products ending up in the wrong hands. The FCA are also charged with ensuring there is sufficient innovation so they won't ban products unless they are misleading.

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Alwaysright

Apr 12, 2013 at 10:02

Any product that suggests it might be able to outperform the market without exposure to additional risk is fundamentally fraudulent.

End of.

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SP

Apr 12, 2013 at 10:11

Just waiting for someone to call Structured Products 'Toxic', then when traditional funds fail they can also be labelled the same, and then we can all invest in cash on a poor interest rate and prop up the banks...... not a bad idea!

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Londoner

Apr 12, 2013 at 10:17

Those who sell structured investment products could start by removing the term "capital protected" from their marketing materials. The capital is certainly not protected from counterparty failure, nor is counterparty failure in itself covered by FSCS.

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Nil Satis

Apr 12, 2013 at 10:20

@SP - then a bank collapses and deposit accounts above £85k are toxic etc etc etc. Structured have a place, not for everyone, but should be considered as part of an overall portfolio. We currently shy away from funds with investment banks as counterparty, but are happy to consider those issued by state owned banks

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Thatcher's Gold

Apr 12, 2013 at 10:56

Alwaysright......always wrong! Here's why.....

Imagine a capital protected note (structured product) which offers 100% protection against market risk and 100% participation in the rise of the FTSE100. (Granted this wouldn't be available today due to interest rates but they have in the past and will be again in the future, in fact there have been minimum return plans offering more than 100% protection). In this instance there is NO additional risk than there would be investing in the top 100 stocks directly, in fact there is added protection and no market risk.

You may not get dividends, but in return you are being protected from market risk, so that's a choice not a risk.

Oh yes I hear you scream, there is counterparty risk, got you! But hang on a minute, what is counterparty risk? It is the risk that your investment return may be lost if the issuer goes bust. Every single equity carries counterparty risk and the credit rating of the banks is much higher than your average equity, so its not an additional risk at all.

I bet you have sold bucket loads of corporate bond funds as low risk when in fact a corporate bond is.............yes you've got it..........a structured product!

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Jonathan Kirby

Apr 12, 2013 at 11:30

But corporate bonds are not derivatives and hence not structured products.

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Hickky

Apr 12, 2013 at 11:37

Ok, well done Martin, you have opened a can of worms here and it is already leading to a polarisation of views. To my mind there are three types of structured product available; a Structured Deposit, a public offered Structured Capital at Risk plan and the commercial notes often used by stockbrokers and DFMs.

I see little risk in Structured Deposits to the public, but their gamble should be against only one mainstream index to be understandable by investment rookies. Public SCARPS should not be exotic or have returns linked to anything else but a single index, but should be allowed to provide access to different asset classes for different SCARPS. These should not be permitted to be sold individually unless to enhance a new or existing portfolio.

Commercial structured notes should not be allowed to be owned by an individual unless contractually overseen by a stockbroker with discressionary powers. This reduces the risk and allows a sale when in the money, or disposal if it looks like not going well.

Although all these notes are written for a set term, it does not mean they can't be disposed of early, but so many providers place barriers to prevent the public doing so. Often they have hidden penalties or deliberately limit the second hand market availability.

Nothing wrong with structured products per se, but the providers of public offerring need to clean their acts up and treat customers fairly.

Mind you, I also feel the majority of past sales were made by lazy advisers or banks who couldn;t be bothered to sell a proper portfolio to those with little investment knowledge, but just wanted the commission.. I rarely sell them, but always consider them first!

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Thatcher's Gold

Apr 12, 2013 at 11:50

But structured products are corporate bonds....unsubordinated debt instruments, debentures, whatever you want to call them.

The derivatives element is a red herring. If you buy a corporate bond from Tesco offering to pay you 5% coupon, how do they get the coupon? They get involved in all sorts of complicated commercial activity, which will involve hedging some business risk with derivatives at some point, probably against meat prices or something, and then pay you a return from their P&L.

This is exactly what a bank does with a structured product. The fact that they disclose their 'calculation method' and the fact that they use derivatives to protect themselves against risk is irrelevant to the client as the client is buying nothing more than a promise to pay from the bank, however it gets the money. If the banks loses on its hedging strategy then it still has to pay from other sources.

A fixed rate deposit account is a structured product. The bank buys derivatives to enable it to pay the fixed rate of interest when due. the strategy employed by the bank is the same, just they don't explain how they are doing it. The promise to pay is the same, as is the counterparty risk.

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Thatcher's Gold

Apr 12, 2013 at 11:51

Hickey.......................Mind you, I also feel the majority of past sales were made by lazy advisers or banks who couldn;t be bothered to sell a proper portfolio to those with little investment knowledge, but just wanted the commission.......

Spot on!

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Hickky

Apr 12, 2013 at 11:52

@ Sandford Cider Drinker (ohh agggh ohh aggh)

A corporate bond is a loan to a company for a set time for a set interest and return of capital at maturity. Risk is related to the company's ability to pay the interest and it's ability to repay the capital at maturity. How does that make it a 'Structured Product'?

A Structured Product is not a loan and normally has a variable return at maturity dependant on market conditions. Rarely does it pay set interest. Risk is related to the issuers, the derivitave providors and any other counterparties risks.

Both can be sold prior to maturity, the Corporate bond on an established exchange, the Structured Note either on a limited exchange of the derivitave issuer may prefer to buy to cancel.

Now maybe you will not make silly comments fuelled by an over indulgence of West Country's Finest.

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Jonathan Kirby

Apr 12, 2013 at 11:53

To get back to Mr Wheatleys point

Overly complicated!!!!!!!

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David Prior

Apr 12, 2013 at 11:54

@ SP

A huge number of structured products were sold BY Banks - taking money out of their own deposits to earn the commissions on them.

One of our staff used to work for Lloyds TSB - he left after being trained to sell one of their plans in a way that was clearly misleading to their customers - which has subsequently blown up and they are paying compensation

He complained as he felt the way they were being told to explain it to customers was obviously misleading - we have come across one client whom they advised to put £300,000 into it and the losses were incredible.

Now the Banks have no "advisers" in the branches they are selling them off the back of leaflets, with "helpful branch staff" passing the leaflets out like sweets to kids, but clearly not encouraging or advising anyone as that would be breaking the rules..............

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Philip Wise

Apr 12, 2013 at 12:05

Wheatley is clearly media savvy, and has a good turn of phrase. I wonder if he is any good as a regulator.

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Thatcher's Gold

Apr 12, 2013 at 12:21

Sorry Hicky you are wrong on this one, despite your previous post being very good.

A structured product is an unsubordinated debt instrument issued by a bank, a loan note, the popularist term being corporate bond. It is a form of capital raising.

A loan does not have to offer a fixed rate of return, the formulae for calculation can be whatever the lender decides upon. It can be decided on who gets relegated from the Premiership this year or what the temperature is going to be on Sunday, both of which are by now probably more interesting subjects.........

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Bridge North

Apr 12, 2013 at 12:23

Is this Wheatley fellow the same one who wrote 'the devil rides out'?

scary book he didn't need to add in structured products to make it confusing and even scarier.

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Hickky

Apr 12, 2013 at 12:34

@TG If banks used money in term deposits to buy derivatives to obtain the fixed return, then how could they use the multiple of this money to fund commercial loans? Is the interest from loans that pay interest on deposits. When banks like HBOS used derivitives they came unstuck. No bank could use this method of de-risking currently because they have found out the process of de-risking carries a higher level of risk that the original risk!

A corporate bond from TESCO, say the 6% 2029 issue currently trades for £124 ish. What TESCO do with the £100 loan is immeterial. If you buy it now you will get £6.00 p.a. for the next 16 years (£96) and £100 back in Dec 2029. Thats it! You can sell it at anytime, you may get more or less than you paid for it. The return expressed as annualised interest is about 4.5%. if you bought today. The only risk is the continuing ability of TESCO to service this loan.

So corporate bonds are not structured products and structured products are not corporate bonds. There may be some similarities in risk profile, but one is a loan to a firm, the other is a promise. Totally different!

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Hickky

Apr 12, 2013 at 12:40

@ Bridge North

There is a computer game called 'Sector W'

Wheatley as a character is described thus:

Wheatley, once an Intelligence Dampening Sphere attached on GLaDOS, is a loose Personality Construct and was briefly the deuteragonist in the single-player campaign of Portal 2. He is one of the many cores seen awakening at the end of Portal, although he had previously been awake before GLaDOS' takeover of the Aperture Science Enrichment Center.

Speaking in a masculine voice with an English West country accent, he is Chell's sidekick and guide during the first half of the game.[6] He assumes control of the Enrichment Center during the game's second half and is immediately driven mad with power, becoming Portal 2's main antagonist.

We will see if this is accurate in due time.

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Thatcher's Gold

Apr 12, 2013 at 13:32

@Hicky

I don't disagree that the banks funding models have got a little messy, but the fact is there is so much cross subsidy, and has always been the case.

The answer to this is to look at where they sit on the banks balance sheet; unsubordinated debt. Whether the bank issues debt as a 'typical' corporate bond or as an SP is not distinguished because they are issued under the same debt issuance programmes.

We are splitting hairs really. The point is that you are lending money to a bank and the banks are, whether we like it or not, actually a better credit risk than many of the companies that issue corporate bonds, so counterparty risk shouldn't get blown out of proportion by those who do (not saying you do).

Yeah, yeah, Lehmans, I know. Bad political decision that will never happen again. The fact is that the banks are, regrettably indispensible and will never fail because everyone (even fund managers and the firms who's equities they invest in) need a bank account. In order not to meet its obligations a bank must be 'in default' which isn't going to happen to a 'retail' bank. therefore counterparty risk is miniscule in comparison to market risk. Markets go down all the time, banks default once in a blue moon.

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Hickky

Apr 12, 2013 at 14:12

@ TG

It is not the risk of the issuer that Wheatly is refering to, but the sometimes convoluted ways these products are marketed. I makes no sense to link the performance of three equities to the return for a public SCARP, no matter what asset class they represent. Why not just buy those three shares? If you want to diversify a portfolio into riskier areas, such as the MICEX or SOFIX then a specialist SCARP could be used, but if marketed on a stand alone basis and not as part of a portfolio, they become nothing but a bet, not an investment and are subject to abuse.

Counterparty risk is normally such a minor part, Lehmans gave the compensation lawyers an excuse to attack, so even more paperwork needs to be dumped on clients to worry them even further. I don't agree the allowing of them to go bust was a bad political decision. It would have been better if Northern Rock was allowed to go as well. I cannot understand why we don't have to advise clients of the earthquake risk if one happened in London, or an otbreak of birdflu in New York.

Too many products nowadays are structured to maximise profits and obscure issuer income. How many new simple vanilla active funds are launched nowadays? Every single new issue seems to have some type of twist for the marketing men to fix their greedy eyes on, often with little client benefit, but upping the fees.

Structured Deposits and SCARPS aimed at the retail market need to be simple, understandable and be able to be cashed in early for a reasonable price.

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Thatcher's Gold

Apr 12, 2013 at 14:59

@Hicky

You are right that the products should be led by consumer demand and not just a jolly good wheeze by the product designer.

Where MW is being a bit naive is referring to only part of the product make up. I did some research and backtesting on a basket of 3 stocks which Merchant Capital launched (before they went bust!), and because they used a defensive structure around the stocks (it was a KO plan where the threshold reduced each year, down to about 60% by the end), the actual probability of payout was better than a typical FTSE100 plan.

Also the coupon was much higher, so the ratio of coupon per unit of risk was much better.

So its not about the 'underlyer', but the whole package.

Anyway, its nice to chat but the desk looks like a bombs hit it, so need to get back to the day job!

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Sascha K

Apr 12, 2013 at 15:15

@Hickky: I don't know where 'Sector W' comes from but the game is called Portal 2, and a very good game it is too.

In non-wiki language, Wheatley is a robot (an AI, if you want to nitpick) who performs the role common in computer games of guiding the player through the early stage of the game. His 'help' however tends to verge from statements of the bleeding obvious to Corporal Jones-esque panicking.

Later in the game (spoilers!) he gains a position of power far above his limited intelligence and falls into crazed megalomania as a result, and must be stopped by the player to avert total disaster.

I can't see how this could have anything to do with the head of the FCA.

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Bridge North

Apr 12, 2013 at 15:25

@Hicky

scary bloke that Wheatley, wrote a lot of very near the knuckle horror books.

must have got this new job from bumping into an old school chum skiing in Zermatt. talented fellow I hear now turning his hand to you financial types.

I hear that Young Potter is being hired as an investigator due to his super wizarding skills particularly Occlumency.

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Hickky

Apr 12, 2013 at 15:37

I stand corrected Sacha, I have no idea about online games. I also have no clue why I thought there was any synergy with MW. Idle curiosity I suppose.

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Captain Runaway

Apr 12, 2013 at 16:22

The cake is a lie

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Luxemburg3r

Apr 13, 2013 at 10:57

Horses for courses. There is nothing wrong with Structured Products, the problems lie with the people who advise on them and the clients who buy them.

I have copies of several Master Note Programmes used by the investment banks to issue various notes. These programmes and the issued notes are all "irrevocably and unconditionally guaranteed" by the parent bank, not the bank holding company.

A note is no more than a corporate bond, a promise to pay, based upon the full faith and credit of the issuer. What the issuer does with the borrowed money is completely irrelevant. On balance sheet or off balance sheet.

Structured products offer choice to investors. Take the market risk and enjoy the potential for growth and the dividends or remove the market risk and enjoy a fixed (defined) return. If you think the investment bank is too much of a (counterparty) risk, don't buy the product. If you don't understand the product, don't buy it.

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Luxemburg3r

Apr 13, 2013 at 13:17

@ Hicky

A Structured Deposit comprises cash on deposit and a derivative package, usually sold OTC, collateralised or not, by an investment bank. The deposit taker will swap LIBOR (flat, plus or minus) with the investment bank for the defined return from the derivative package.

The deposit taker has the benefit of the cash on deposit for the term of the investment and its treasury department spends all day hedging risk, often using derivatives of one shape or another to achieve that aim.

Many, many corporate bonds are issued as structured products. Medium Term Notes are corporate bonds issued by banking companies and often these are structured investments. Most major banking companies have revolving, multi-billion dollar note programmes established in The Channel Islands by their securities division (investment bank), off which they issue MTN that underpin structured products.

I suggest hundreds of billions of corporate bonds have been issued as structured products. If you don't believe me, just spend some time on Euroclear where you will find every type of corporate bond you can imagine.

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Hickky

Apr 13, 2013 at 17:19

@lux3

Whilst there are a number of instruments that may be classified as corporate bonds, most funds are not using those you describe for the bulk of their investment. It saddens me that as advisers we cannot directly advise clients on individual corporates traded on the London smaller exchange. I have always felt that although equities benefit from an open ended structure that reduces risk, corporate bonds risk is increased as they are term limited. This is the main misunderstanding that regulators and the FOS do not get.

Thanks for the heads up anyway. I'm off to Amen Corner now.

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Luxemburg3r

Apr 13, 2013 at 18:16

@Hicky

I think you may be surprised that funds do buy these bonds via private placement and not public auction.

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