A tale of two Januarys

The last twelve months will no doubt have a residual impact in all walks of life – be it social, cultural, or even financial. Over the coming years it will be interesting to witness the extent of a ‘new normal’, be it for better, or for worse.

Though we are by no means finished with the pandemic, there is light at the end of the tunnel with global vaccination programs well underway, and markets appeared to have calmed following increased volatility throughout 2020. As such, it feels fitting to observe how the UK retail structured products sector has changed and if we are at the beginning of a ‘new normal’ for the industry.

Naïve to what was to come, January 2020 was a strong month for UK stock markets. The FTSE 100 Index, which has been the most common underlying for UK issuance for the last decade, enjoyed an average position of 7,558 (Investing.com) on the back of a bull run following the December 2019 general election. A function of the sustained bull markets helped boost maturity numbers to 45 in January 2020, with 39 new plans issued in the retail space.

Twelve months and three national lockdowns later, January 2021 represents a far less favorable snapshot for the UK in general, not least the stock market. The average FTSE 100 Index level for the month was 6,698.52, and despite a short rally to 6,903.61 on the 7th (Investing.com), the Index closed for the final day in January 2021 at 6,407.46 – over 1,100 points below the average Index level of the preceding January. Just 13 plans matured throughout the month, and 34 plans were on offer. The Investec / Lowes 8:8 Plan 7 was the only autocall contract to successfully kick out in January, maturing on its second anniversary returning a gain of 16% - despite a 3.27% fall in the FTSE 100 Index.

Consistent with the recent history of the sector, FTSE 100 linked capital-at-risk autocall / kick-out contracts remained the most prevalent new issue, however there are some fundamental differences between the two months in terms of product shapes.

First, the maximum term. One of the sector evolutions we have observed across the last decade is the movement to longer maximum investment term for autocalls. Following the introduction of the 10:10 Plans in 2015, the average maximum investment term gradually increased sector wide, providing benefit of a degree of ‘Black Swan’ protection. Though we hoped this would never be necessary, these longer, maximum durations will continue to provide much welcome peace of mind if a recovery is not swift. Whilst hopefully a lot less necessary following the 2020 correction, many counterparty banks are currently reticent to issue terms with longer potential durations. The result being that whereas in January 2020, the most common maximum investment term of new issue FTSE capital-at-risk autocalls was 8 years, whereas in January 2021 it had dropped to 6 years.

Further, in January 2021 the modal capital protection barrier amongst new issue FTSE linked capital-at-risk autocall plans was 65% thereby providing less protection from market falls than plans issued in January 2020 when the typical barrier was at 60%. Again, the lower market position should hopefully mean this is inconsequential from an investor’s perspective but it’s not a positive move.

A significant contributing factor for the reduced appetite for longer durations and reduced capital protection being offered is the dividend forecast. In 2019 the FTSE 100 dividend yield was 4.35% whereas by the end of 2020 it was forecast to be below 3.5% (Mariana Capital). This, and more importantly, the unknown impacts pricing. In response the sector has responded with the introduction of the FTSE Custom 100 Synthetic 3.5% Fixed Dividend Index (FTSE CSDI), which we believe should become a staple within the sector over the coming years. The FTSE CSDI aims to closely replicate the performance of the same 100 companies as the FTSE 100 Index, but after including the dividends – the equivalent to the FTSE 100 ‘total return’ index, from which, a constant annual dividend of 3.5% is deducted. The FTSE CSDI index may therefore be expected to perform in a similar way to the FTSE 100 Index although, it would be expected to slightly underperform the latter if the total dividend yield transpires to be less than 3.5%. The correlation of FTSE CSDI to the FTSE 100 over a 10-year simulated back-test is 98.26% (Mariana Capital).

By removing the uncertainty of managing future dividends, the issuing banks may face lower costs and risks. The risk, or even the expectation that dividends will be lower than 3.5% is, in turn, accepted by the structured product investor but the acceptance of this, together with the cost saving arising from the issuer not having to make assumptions on the dividends, ultimately leads to greater potential returns for the investor.

For more information regarding the FTSE CSDI, please visit here.