Home > News > 2003 > September 2003 > Precipice bonds renamed as investors take the plunge
Precipice bonds renamed as investors take the plunge
Pete McGurk, a partner with the Life team discusses the newly renamed precipice bonds.
Many investors are regretting their decision to invest in so-called "precipice bonds" in the wake of the recent stock market falls. These products typically involve the payment of a lump sum into a product that promises a high annual income payment and a return of capital providing some stock market-based measure, usually an index such as the FTSE 100, performs to a specified minimum level over the life of the product. A typical term for the product might be five years but higher and lower periods are not uncommon. If the index under-performs, investors may not get their full capital back and their return will drop ever lower as the index or other measure falls further - hence the name "precipice bond".
An example
At a time when deposits or fixed interest bonds only yielded interest payments of 5% p.a. or so, a "precipice" bond might have offered income payments of 9% p.a. plus a full return of capital at the end of five years providing the FTSE 100 index at that time was not below its value at the time the bond was taken out. If the final value of the index falls below its initial value, the capital return would be reduced proportionately.
If the bond was taken out when the FTSE 100 was 6,000 (say) and five years later when the bond matured the value was 6,500, a person who invested £100,000 into the bond would have received £9,000 per annum income for each of the five years. Their capital return would be the full £100,000 invested. This is illustrated as the first case in the figure below with a total payout over the life of the bond of £145,000.
If, however, the value of the index were only 4,200 at maturity, then the investor would still receive the £9,000 per annum income. Their return of capital would, though, reflect that the index had fallen below the precipice and their return would therefore be:
100,000 x (4,200 / 6,000) = £70,000
This is illustrated as the second case in the figure below with a total payout of £115,000 over the five-year term. This would still give back more than was invested but give a relatively poor return over the life of the bond and possibly create problems if the investor was expecting or depending on a full return of capital at maturity.
The overall payout would continue to fall as the index gets lower until the breakeven point at an index level of 3,300 where the total amount paid out, including income payments, equals the amount invested. Below this level the investor would suffer an overall loss.
Unfortunately, many investors who took out these bonds a few years ago now find themselves in something like the position outlined in the second case.
Design variants
There have been many variants of design on such bonds. The stock market measure used may not be a single index but the worst (or best) performing of two or more indices or a number of individual shares. The "precipice" may be set higher or lower than the initial value of the stock market measure. The capital return may be subject to a "floor" below which it cannot fall irrespective of how badly the stock market performs, a common floor might be such that the overall payout (including income payments) never falls below the initial investment. Some bonds may contain features to reduce the volatility of returns, such as averaging the final value of the index over a period but others may have features that work the other way, such as "gearing" the impact on returns by, say, reducing the capital returned by 2% for every 1% fall in the index. In some cases the term of the bond may not be certain and may itself depend on the index performance.
In general, the old adage that "there's no such thing as a free lunch" applies. The more that the rate of income offered on the bonds exceeds the rate available on deposits, then the greater will be the risk to capital. The difficulty for investors and their advisers is in trying to appreciate the magnitude of the risks and, in some cases, in recognising that the risks exist at all.
Who's been providing these bonds
There are generally two parties behind these products. The first party is the product provider that the investor enters the contract with. A number of different types of institution have sold them including insurance companies and fund managers, both onshore and offshore.
They also have been presented in a number of different product "wrappers" including life insurance policies, PEPs and ISAs. Many are shares in closed-end investment companies listed outside the UK. Many fall outside the regulatory definition of a "packaged product" and therefore fall outside the Conduct of Business regulations that govern the sales process for, say, insurance policies.
The second party, almost invariably present, is a bank that sells a structured derivative contract to the main product provider that exactly matches the benefits of the contract and, in some cases, also provides for any taxation payable by the provider. It is effectively a "wholesaler" and "retailer" set-up. The cost of the matching derivative will be less than the lump sum received from the investor, the difference being used to fund any commission payable to intermediaries and the administration and marketing expenses of the provider as well as an element of profit to the provider.
As far as the investor sees it, the bank is very much in the background and the legal contract and customer contact is all with the primary provider.
The main issues
These bonds throw up a whole raft of issues, the key ones being:
The magnitude of the risk to capital may not have been appreciated at the time the bonds were purchased and, in some cases, the investor may have been unaware of any risk at all. In any event, the magnitude of the risk is difficult to assess for most people and the risks involved in the more complex variants even more so.
A high proportion of the bonds are purchased by elderly people seeking to earn an income on their capital and are taken as an alternative to deposits or conventional guaranteed income bonds. These people are typically risk-averse.
Many of the bonds are sold directly to investors from advertisements and promotions. They do not therefore involve advice from an intermediary such as an Independent Financial Adviser (IFA) who should be able to provide an investor with a more informed commentary and recommendation in the light of an individual's circumstances.
The promotional material used to market some of the bonds may have inadequately explained the risk to capital or given excessive prominence to the high rates of income and relegated the capital risks to the depths of the small print. The material may have acknowledged the risk but sought to portray it as negligible.
Investors whose bonds have yet to mature may not realise, due to lack of ongoing communication, that they may receive considerably less than their original capital unless stock markets recover dramatically from current levels. They may not therefore be making appropriate financial plans.
These bonds are not suitable for investors who require instant access to their capital. They are designed to run for a specific term and any earlier cash-in value will usually depend in part on the amount that the bank will offer the product provider to cash-in the underlying derivative. There may be little incentive to be generous.
The products are often structured so that the returns are effectively linked to the proceeds of the underlying derivative i.e. any default on the obligations of the derivative provider is not absorbed by the product provider but passed straight on to the investor. While the bank involved is often part of a well-known global banking group, the existence of this additional counter-party risk is often not appreciated by investors.
So what is being done?
These products are not bad per se. To a well-informed or well-advised investor they may well offer an attractive blend of risk and reward. Nobody has suggested that more established stock market investments should not be made available to private investors due to the risks to their capital. The issues generally concern the policyholders' understanding of the product and the risks at the time the purchase decision is made and the provision of ongoing information to assess likely overall returns.
Concerns have been expressed by a number of parties, including the actuarial profession, in recent years. Those of us connected with the insurance industry have been aware of the FSA's attempts to stop the sale by insurers of some of these products by the use of the somewhat arcane rules on the use of derivatives. This has effectively put a stop to the sale of some variants, e.g. multi-index bonds, by insurers and driven a lot of the business out of the insurance sector and into the fund management (particularly offshore) sector where the regulatory environment is more benign.
In February 2003, the FSA issued Guidance Note GN7 without consultation in order to protect consumers and potential consumers. This defined the term "precipice bonds" and provided guidance for firms that market them to:
- Provide a clear explanation of the risks
- Include a copy of the FSA's factsheet on High Income Products
- Provide ongoing periodic information on investment progress including a statement of the projected maturity value if the relevant index/indices remained at the level(s) prevailing at the time of the statement
Consultation Paper CP188 was published by the FSA in July 2003. This introduces a new product-type - Structured Capital-at-Risk Products (SCARPs) - which embraces and the previous definition of "precipice bonds".
The proposals will carry over and develop the main features of the temporary GN7 and put them into the FSA's Handbook and make some of the requirements into absolute rules rather than just guidance.
Conclusion
These products are sure to attract more bad press as they mature in adverse stock market conditions and investors, often elderly, receive back a lot less than the capital they put in. In these conditions, further attention will focus on the sales and marketing process and many complaints may be received as to the extent that the risk of capital loss was made clear. This will put further pressure on advisers, product providers and the regulator to ensure that compensation is paid where appropriate. Lloyds Bank have been reported as making significant provisions for compensation payable to investors in these bonds.
All products in the SCARPs genre are likely to be tarred with the same brush. All involved in the sales process should satisfy themselves that risks were and continue to be adequately explained to consumers and potential consumers and that this can be evidenced if required. Otherwise the risk of compensation payments is a very real one.
Pete McGurk, September 2003.