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If the backer of a structured product goes bust

This article is part of
Guide to Structured Products

Counterparty risk can vary from sub-investment grade debt through to government debt, according to Adrian Neave, managing director of Gilliat Financial Solutions.

Most often the risk will lie with a single issuing bank (the issuer) that has an investment grade credit rating from the major agencies.

If the issuer fails, investors can lose their total investment. As with any investment, it is therefore important to consider exposure levels to individual counterparties.

Adrian Neave, managing director of Gilliat Financial Solutions, says a diversified counterparty exposure is wise.

Mr Neave says: “Where there is a provider that is different to the issuer the demise of the provider will not necessarily mean that investors will lose money.

“Keydata and NDF are cases in point here (note losses at Keydata related to life settlement products, not structured products) where although the provider went into receivership, investors structured product investments carried on and delivered the returns a ‘promised’ by the issuers.

“In this case the demise of the provider is really an inconvenience as opposed to a calamity.”

Credit ratings are the most common form of credit assessment and are used by investors of all levels of financial sophistication.

However, Ian Lowes, founder of StructuredProductReview.com, says it is important to realise credit ratings are not completely infallible and ratings agencies struggled to stay ahead of the curve during the major financial crises of the past few years.

Mr Lowes says advisers should always consider the implications that a resulting loss would have for the investor should the counterparty fail and diversify their portfolios appropriately.

To mitigate counterparty risk, Mr Lowes points out some plans are collateralised - this is where the money raised by the issuing institution is not held on its own balance sheet but invested into collateral assets.

The collateral itself can be varied in nature but is normally made of securities such as government bonds (gilts), cash or loan obligations of other financial institutions.

The collateral is held by a separate custodian and the value is normally adjusted daily to match the value of the plan.

Mr Lowes says some product providers have started to introduce new styles of collateralised plans where the credit risk of the investment is spread across multiple banks/ institutions.

These plans can mitigate the problem of single issuer risk, he points out.

While diversification of risk is a much vaunted investment principle, Mr Lowes says it is important to understand that material credit risks remains with these plans.

With regard to the provider, rather than the counterparty, defaulting, Mr Lowes says this potentially has little impact on the returns offered by the product.

He says: “We have seen examples of this in the past, for example with Keydata when, despite the collapse of the firm, the structured products that it launched remained intact and have been producing the returns that they offered at outset.