Gilliat looks at lower tier debt for structured products

Gilliat is planning to put together products using debt from lower down the capital structure as it becomes difficult for providers to offer as attractive returns compared to previous plans.

Changing market conditions are making it harder for providers to get competitive prices on bonds underlying structured products. The price a provider has to pay for the bond, the “funding rate” is affected by its credit provider’s credit default swap rate.

The lower the credit default swap rate, the lower the perceived risk of default of the firm and so the more expensive the bond.

This means that when banks are buying more expensive bonds, they have less money to spend on the option and returns are therefore less competitive.

This has lead providers like Morgan Stanley to bring out new versions of plans with lower returns. For example, the Defensive Bonus plan 5 had a 10 per cent per annum coupon, but this was followed up by replacement product, which has an 8 per cent per annum coupon. The latest Gilliat Income Builder was yielding around 6.3 per cent, but a previous version offered a coupon of 8 per cent.

Gilliat Financial Solutions managing director Adrian Neave says: “Post RDR, we are likely to see different asset classes used for products and different pay-offs as well, as funding is getting so bad at the banks and is not getting any better.

“People are going to have to accept that where they want high coupons, they are going to have to look at riskier assets or a riskier combination of assets. They may have to look at debt that sits lower down the capital structure.

“Using debt lower down the capital structure is something we will be rolling out next year. We have an Income Builder product at the moment that is yielding around 6.3 per cent. We can create a version of that using subordinated debt that will yield closer to 10 per cent.”

Previous versions of the Income Builder have used senior unsecured debt and this is what Gilliat uses in the majority of its UK retail products, barring a couple of special purpose vehicles. Senior unsecured debt is the majority of issuance in the structured product market.

Neave says that investors should not become so reliant upon credit default swap rates when assessing the risk of products and should look at liquidity rates of banks, which are published twice a year.

He says that with these sorts of products that are using debt from lower down the capital structure it is key to illustrate to investors what the debt is.

Neave adds: “We are looking at the way we present risk on asset and credit to investors so that we can allow a broader range of clients access to payoffs. Those who want to take more risk, if they call it right, can make more money.”