Germany 2006 Less is more
Retail derivatives-based structured products are huge business in Germany. Nevertheless, dealers hope to increase volumes significantly in this rapidly evolving market by returning to the market's roots. Mark Pelham reports.
The outstanding value of structured products held by German retail investors is estimated to exceed €80bn. For the most part, such products are issued as certificates – essentially debt securities issued by banks that provide synthetic exposure to any underlying asset class – a format that provides tax breaks for the investor if the certificate is held for a qualifying period.
The tax breaks are an added plus for investors, but would not be sufficient to sustain such large volumes on their own. The fact that German mutual funds only enable investors to buy upside – if they are looking for downside protection, certificates provide the only vehicle – has undoubtedly contributed to the product's popularity but there is also the way the market itself is structured.
“One of the reasons why this market is so successful is because the industry looks after retail investors only – in other markets, people try to sell the same products to both retail and institutional investors, which often doesn’t work. At the same time, that means if you can’t explain the pay-off formula in three sentences, you will have difficulty selling a product," said Klaus Zimmermann, deputy global head of the retail solutions group at Dresdner Kleinwort Wasserstein.
Despite such ease of explanation, Christophe Kauff, head of trading in DrKW's retail solutions group said: “Some of these structures are highly complex from a pricing perspective. Consequently there is a need for constant development in terms of pricing models to enable structuring firms such as ourselves to have a leading role in this area.”
The need for that constant development can be seen in the rapid evolution of structures in the market in recent years. While it began with straightforward delta 1 products linked to indices, the latest structures involve an array of exotic options.
With investors looking for ever more significant returns over the past three years, the array of structures has grown exponentially. First came discount certificates, which allow investors to replicate the performance of a given stock, index or equity basket at a discount compared with the actual underlying price. The potential gain, however, is limited to a pre-defined level.
The popularity of ‘discos’ has been superseded by bonus certificates, which provide a conditional guarantee. The certificate offers a pre-determined threshold through which the underlying price can not fall during the life of the product for the holder to receive a bonus payment at maturity of a percentage of the starting price But should the underlying price be higher than the bonus level at maturity, that is paid out. However, if the bonus level is breached during the products lifetime, the closing price at maturity is paid out.
Bonus certs remain the most popular non delta 1 products today – not least because dealers can structure them fairly easily using a zero strike call plus a down-and-out put – but variations on their theme have emerged in the past 12 months. One of the most active of those variations are callable structures, which can be divided into two groups: auto-callables (sometimes called ‘easy return certificates’ or ‘express certificates’) – where the investor has the potential for a series of annual payments but will be called in any one year if the underlying has performed above a pre-set level positively – and soft callables, which emerged at the end of 2005, where the issuer has the right to call the structure after a certain period (one or two years).
Of the even more exotic products available, the most popular last year was the butterfly certificate. These enabled investors to gain on any rise in an underlying price up to a certain cap, as well as gaining on decreases of the oil price up to a certain barrier.
Since the start of 2006, there have also been a growing number of so-called alpha or out-performance products being introduced to the German retail market. With these certificates the return is dependent on the out-performance of one underlying versus another, which can give positive returns even if both underlyings go down in value.
While the appeal of such products is clear, increasing complexity has brought with it some difficulty. The disparity between expectations based on redemption formulas at maturity and the reality of secondary market values a short way into the term of the contract has caused some investor concern and led to issuers shortening product maturities. In the past, the focus was on five, seven and 10-year terms. But now the most popular products are between 18 months and four years.
Focus is also changing in terms of product underlyings. While equities remain the most popular by some considerable margin, accounting for as much as 85% of structured products, there is a rise in interest in other asset classes.
“German retail investors seem to prefer not to be involved in fixed-income, having been discouraged by the decline of many of the structures sold in other countries because of the flattening of the yield curve. However, commodity-linked products are becoming more popular primarily thanks to the oil rally. There is also an increased interest in gold and we have even issued a product where investors can participate in CO2 emissions trading," said Zimmermann.
Kauff added: “The other market where we and others are increasingly active is hedge fund-linked products, where we have issued in Germany a total of six certificates. We issued our first certificate in 2001 and it expires in March, so we issued a new one at end-2005 and have placed more than €750m into it.”
Overall, the market is offering investment opportunities on a broader horizon, according to Dirk Singer, part of the structured products distribution team for Germany and Austria at JPMorgan. “It’s more like a multi-asset product range but there will still be a focus on equity underlyings, especially now that the market has regained some momentum. Over the last month demand for certificate products has re-emerged strongly, where people are willing to take some risk as opposed to purely relying on capital protected products,” he said.
“The future growth potential is large in terms of structured products,” Singer continued, “but I don’t expect the number of different kinds of pay-outs to grow massively because there has been so much innovation already done in that respect over the last few years, especially for capital-protected products. Correlation products aren’t going to be used that much because indices have become more popular again, but I expect a more diversified approach in terms of underlyings used, which are likely to be more international and research driven and increasingly include commodity underlyings.”
That diversity is clear in the wide range of delta 1 index certificates now available. Only a few years ago, the market was dominated by products based on the DAX, but now dealers report demand for emerging market equity products – particularly for Brazil, Russia, India and China.
At the same time, there is strong interest exotic currency and/or emerging market interest-rate certificates, where the currency is relatively stable but rates are high. For example, Turkey, which has rates at around 14% but the currency range-trades against the euro. Equally, Brent crude oil is growing in popularity as an underlying and there have even been some certificates structured around baskets comprising a number of individual commodities.
Inevitably the latter type of instrument is likely to remain a niche product for a small number of expert investors, but the aim for the German retail structured products market as a whole is widespread expansion. As such, getting the message out of the market’s benefits is key for structurers.
“Going forward the biggest theme in Germany will be customer education in order to attract more and more investors to structured products. Obviously it is already a big market, but we believe it will continue to grow very quickly – our figures suggest by at least 200% in the next 3 years," said Önder Çiftci, head of public distribution for private investor products at ABN AMRO.
“That growth will be driven by the fact that so many more people are looking for alternative investments and intelligent products. We already see massive marketing efforts by issuers but know that it is something that can be expanded still further by moving into other areas, fair trade investments for example, thereby attracting new kinds of investors. Furthermore, it will not only be the so-called self-directed clients that will add to the flow of investors, the major local distributors – the big network banks, the savings banks and so on – are now very keen to sell these products too.”
A new sales force of this kind can only benefit from an easing of the explanations necessary from the issuers' new streamlined approach to structuring. As a result, a continuing boom in the market looks to have considerable potential.