Risky derivatives make return for returns' sake
LONDON (Reuters) - Investors facing record low bond yields are increasingly chasing higher returns via complex derivatives, the instruments at the root of the 2008 global financial crisis, which can punch yawning holes in balance sheets if they go awry.
Monetary stimulus from central banks has driven down sovereign and corporate bond yields and sent shares to multi-year highs, which in turn has encouraged investors to buy structured products that bundle derivatives with stocks or bonds to increase returns.
"The low interest rate environment is pushing clients to search for yield," said Sébastien Gyger, head of portfolio management for private clients at Lombard Odier.
"Volume in structured products has been high and has picked up, notably since the beginning of the year."
His clients have been making leveraged three-month bets on some Swiss blue-chip stocks via structured products that offer limited protection on the capital invested.
Popular structured products are chiefly based on shares, corporate debt or government bonds, making them more transparent than those that triggered the 2008 crisis, which wrapped up poor-quality U.S. mortgages, but these products still present risks.
They are typically deals struck directly by a bank and an investor "over the counter" (OTC), not via an exchange, and their bespoke nature and complex terms mean they are much harder to offload than a stock, bond or unit in an exchange traded fund (ETF) if they start making losses.
They also expose their owners to the risk of default by the bank that creates them, unlike shares and bonds.
For these reasons, investors who buy structured products and the banks that issue them will be vulnerable to the volatility that could emerge when central banks eventually unwind their ultra-loose policies.
"When the next volatility bout comes around, with the turn in interest rates, then all it takes is for one bank to go down, and suddenly you're back in a crisis again," said Adrian Blundell-Wignall, deputy director of the Organisation for Economic Co-operation and Development's (OECD) directorate for financial and enterprise affairs.
The notional value of the global OTC market has been roughly steady throughout the crisis and stood at $633 trillion at the end of 2012, according to data from the Bank for International Settlements, a sum with more than enough potential to destabilize the global financial system.
European regulators have been trying to improve safety in derivatives since the crisis. For example, they want OTC derivatives trades to be processed by a central clearing house backed by collateral from market participants, in a bid to isolate the impact of failure by an institution.
A deadline to put these rules in place by 2012 was missed and the process is expected to drag on into 2014.
But critics say these rules merely shift risk from banks to a central clearing institution that would still need a public rescue if the banks that back it run into trouble.
"By setting up this central clearing party, we are setting up the mother of all too-big-to fail institutions," Blundell-Wignall said. "Again, the taxpayer will have to bail out these institutions."
He added that as long as banks' retail and investment businesses were not separated, depositors' money and economically important lenders remained exposed to losses made through risky derivative bets.
European banks had more than $6 trillion worth of derivatives, the key ingredient in structured products, on their balance sheets in March, OECD data showed. These figures also include the value of instruments used to hedge risk.
This is 50 percent more than they had six years earlier, when a crash in structured products based on subprime U.S. mortgages triggered the global financial crisis, leading central banks to cut rates and launch stimulus measures.
The impact of these moves was to lower bond yields and push fund managers to higher-yielding securities, including structured products, to improve their performance.
The number of new structured products sold via UK independent financial advisers is up 60 percent from its 2007 levels, and notes that put investor capital at risk have gained prominence, according to data from StructuredProductReview.com, a site that tracks the industry.
Issues of structured products with no or limited capital protection have outnumbered those that guarantee the repayment of any initial investment by three to one in Britain this year, the data showed. In 2007 the ratio was reversed.
"(Central banks) have probably removed the downside tail risk and as a result encouraged investors who previously were out of the market to get engaged again," said Oliver Gregson, global head of discretionary portfolio management at Barclays Wealth and Investment Management.
Gregson added his clients were buying "supertracker" notes, which magnify returns if the underlying index rises, in return for a partial exposure to losses in the event of a fall.
Capital-at-risk products are primarily bought by private wealth managers, who have more flexible mandates and target higher returns, while insurers and other institutions catering for retail clients tend to buy protected notes.
"Private wealth management clients are looking for a yield of 5 to 10 percent per year, and to have this return you need non-capital-guaranteed products," said Benoit Petit, managing director of cross-asset solutions at Societe Generale.
CAPITAL AT RISK
Among the most popular products that put investors' capital at risk are multi-year auto callable and bonus notes, which return a fixed coupon as long as an underlying stock or index remains above a certain pre-determined threshold.
But the capital that has been invested starts being eroded if the stock falls below a barrier, often set 20-40 percent below the initial price, which means these products imply a bet that the stock market will not suffer falls of the size seen in 2008 and 2011.
Auto-callable notes and products with similar features account for nearly 60 percent of all structured products sold via independent financial advisers in Britain this year, compared with less than 10 percent in 2007, according to StructuredProductReview.com.
The lack of protection of these products and their complex structure and fees should be a reason for concern, according to Darrell Duffie, professor of finance at Stanford University in California.
"Some investors become impatient for higher yields and take more risk as a consequence," Duffie said. "(But) there is not sufficiently strong and clear disclosure to clients of the implicit fees that individual investors are paying, if not also the risks of these products."
(Additional reporting By Toni Vorobyova, editing by Swaha Pattanaik and Will Waterman)