However, five years on and with banks subject to far more stringent capital adequacy requirements and regulatory scrutiny, and a range of credit risk data available for research, many advisers now may find it easier to consider whether a major bank is likely to be solvent in five to six years time than what may or may not happen to the stockmarkets or, indeed, how ‘traditional’ fund managers will perform over the same period.
Most professional advisers will have a view on the major banks generally. Prior to the financial crisis many had not considered the potential of a bank collapsing but now advisers refer to a range of credit information on the financial institutions backing structured products in the UK.
Don't ignore CDS spreads
An assessment of a bank’s financial stability and robustness can be derived from the ratings of the credit rating agencies, as well as from the credit default swap (CDS) spreads and sovereign information. In addition, the advisory due diligence process can be enhanced by reference to financial fundamentals of the structured product providers themselves.
For example, when assessing structured products an adviser can consider the credit ratings ascribed by each of the three main agencies – Standard & Poor’s, Moody’s and Fitch – looking at the date and direction of the last change and the outlook – i.e. positive, negative or stable – and apply that to product providers and counterparties. This is supplemented by five-year CDS spread levels, the wider the spread the more implied risk, and looking at how the spread has moved over the previous five years. Finally, it can be useful to consider the information regarding the sovereign ratings, including credit and CDS spreads. The data can be accessed for free by advisers through StructuredProductReview.com’s counterparty platform, which includes regularly updated data in a single table.
Accessing a range of reliable data also means advisers can make informed decisions on the risk and return parameters of using products backed by differently rated institutions within a portfolio.
Too negative a focus
In this respect, the focus on the negative implications of credit risk, the chance that a counterparty might go bust, can often overshadow the very definite benefits of structured products that are a direct consequence of this self-same risk. Namely, that the credit rating of the counterparty usually has a direct bearing on the headline rate. Lower rated institutions more often will have to pay higher coupons on the bonds they issue, meaning less of an investment has to be used to provide the capital return element of the product and, in consequence, there is more cash to be used to purchase the options that deliver the potential return on capital.
Another important point to make here is that if the counterparty remains solvent then the institution is legally obligated at maturity to deliver the precise returns stated in the terms of the product. This enables advisers to know what their clients may receive at maturity, given the market conditions, and at what point in time. As such, advisers investing in structured products have two main risks to consider: credit and market risk. In comparison, this cannot be said about the many variable risks of 'traditional' investment funds, which will include market downside, volatility, market timing, active fund management and process risk.
Credit risk remains an important part of the research conducted by advisers when selecting structured products. However, whilst the range of credit risk data now readily accessible may make it easier for advisers to make a call on the robustness of a financial institution, it is important to never forget that no amount of research will guarantee an outcome. With this in mind, diversification of counterparties within a portfolio will still serve as the best method of balancing risk.