Having it all: Equity returns with capital protection

The increased equity market volatility and accentuated market cycles have tested the courage and patience of equity investors many times during the last few years.

As a result over the last few years, investors have been reducing their equity allocations in favour of fixed income and hard assets such as gold and real estate.

However, in the current context of possibly lowering of interest rates and attractive equity outlook, investors are out exploring opportunities to take advantage of equity market growth but are scared to risk their capital.

In such a situation, principal protected equity linked debentures or structured products can be a good option for investors to enjoy equity upside with the comfort of principal protection.

Structured products are typically investments with tailor made returns contingent on conditionality of a market based instrument.

These products have underlying associated with Nifty, stocks, Government Securities and sometimes alternative financial assets such as gold.

A typical Nifty-linked principal protected structure product is an instrument which is a combination of a bond and derivative. Part of investment (say 70 from every 100 invested) gets invested into a bond which over the product tenor, earns and adds interest to achieve the objective of principal protection. The balance investment amount (say Rs 30) goes into a derivative, a call option on Nifty, which is like a contract providing investor right to gain from Nifty upside and with no obligation for participating in case of Nifty fall.

So in such investments an investor enjoys market appreciation when Nifty rises but gets his capital preserved in case of fall in the Nifty.

Apart from the simple example stated above, the world of structured products has seen evolution of many strategies. For example if an investor view is that over three years market will not grow beyond 70 per cent in total, he can enhance his returns through a higher participation. In such case if the higher participation is say 140 per cent, for every 1 per cent gain in the market, the investor makes 1.4 per cent (for 50 per cent market gains, this translates to 70 per cent returns).

However, in getting this boosted performance in 0-70 per cent performance band, he caps his maximum upside gains to 98 per cent (140 per cent participation to 70 per cent growth in market) and sacrifices gains from excess returns over 70 per cent. In another strategy, called binary option, an investor can get a fixed payoff, say 60 per cent, over three years provided the Nifty closes above a predefined level (say 10 per cent higher than the initial level at the time of investment). The call which an investor takes on market level is on the Nifty going up by 10 per cent and hence making much higher return than other fixed income alternative. If this views proves incorrect he gets only his capital back after three years and loses the opportunity of earning interest through FDs or other fixed income options.

Ways to invest

These structured products are manufactured/packaged together by NBFCs as equity-linked debentures and are recommended to investors through private bankers/wealth managers and advisors. Typically, the mode of investment is under a PMS for ease of management, monitoring and transaction. The minimum investment amount is typically Rs 25 lakh. Retail or small investors should not get disheartened by large minimum investment needed for these products as there are Hybrid Close Ended Debt Funds available from various MF houses to play the simplest vanilla strategy of these structures.

Such products launched by multiple AMCs from time to time are typically three year close-ended debt funds offering 80-90 per cent participation to Nifty upside with comfort of 100 per cent capital protection and has minimum investment amount limit of Rs 5,000.

What are the aspects investors should look at before investing in structured products. Lack of liquidity, credit risk of NBFC issuing the debenture, loss of opportunity to earn interest in case view is proven wrong or the impact of market going up during the term but closing below the starting level at the time of maturity are some of the risks which investors should be comfortable with.

While comparing multiple options, an investor should also take note of few parameters like: (a) tenor- a 36 or a 39 month tenor may both look alike but there is significant impact on pricing and attractiveness due to additional three months, (b) Observation dates and their frequency for conditions like callability, knockout etc and (c) Credit rating of issuer – a AAA rated issuer will be more secure and hence might be less attractive on payoff parameters than a AA- issuers which can give improved and more attractive payoffs but comes with a higher credit risk

(The author is Senior Director & Head – Products & Family Office Advisory, ASK Wealth Advisors Pvt. Ltd. The views are personal)

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