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The Actuary The magazine of the Institute & Faculty of Actuaries
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Safe bond or risky derivative?

Banks and building societies are falling over themselves to draw risk-averse investors back into the stockmarket with ‘guaranteed equity bonds’, or ‘structured bonds’.
Some of these schemes are not bonds at all, but are plans which:
– don’t promise anything beyond a share of the eventual proceeds (like an investment trust); and
– are reduced by uncertain expenses (especially on early redemption), like a life-office product.
Others are indeed bonds that promise to pay a specified amount of money, over clearly defined terms.

An example
Let’s look at a typical example: a bond that guarantees, to the extent that a guarantee is possible, no risk to capital plus 100% of the rise in the FTSE 100 index over five years.
If the FTSE 100 index rises from, say, 4,500 to 5,500 (a rise of 22%), an investment of £100 in the bond pays £122 before tax. If the FTSE 100 index falls from 4,500 to any level the same investment of £100 pays £100.

Cash plus call option
This bond can more or less be synthesised by making a cash investment and buying a FTSE 100 call option. The cash investment provides the ‘guaranteed capital’ and the call option provides the extra on top if the FTSE 100 index rises. Institutions offering these bonds have a credit rating of AA at best. AA-rated bonds yield at least 5.5% at the moment. In other words, a zero-coupon bond with current price £77 = 100/1.055^5) would provide £100 with certainty in five years’ time. This ignores credit risk. The remaining £23 is left to pay for a call option plus expenses.
Assuming that expenses are at least 4% (some of the commission rates on these bonds are 3%), the £100 investment is split:

Cash 77 (80% of 96)
Call option 19 (20% of 96)
Total assets 96
Expenses 4
Total cost 100

A question for investors considering these bonds might be: ‘Do you want to invest in cash (80%) and options (20%) with 4% expenses on the lot?’

Why have these bonds appeared now?
Interest rates have risen, making the cash deposit cheaper. Share price volatility is low, making the option cheaper. So bonds can now be offered with the attention-grabbing promise, over an imaginable term of five to six years of ‘100% of capital plus all the rise in the index’ with ‘no risk’.
Despite the magical appeal of ‘100%’, only 77% of the capital is guaranteed and the rest is put into a call option at risk of total loss.
What are options?
Options can themselves be synthesised by geared holdings in the underlying asset plus more or less mechanical trading rules.
For example, a way-out-of-the-money (thus unlikely to pay out) FTSE 100 call option could be synthesised by a small holding of FTSE 100 equities just in case the FTSE 100 index rose, paid for by a small amount of cash borrowing. Assuming the FTSE 100 index stayed low, as the option expired, the equities would be sold and the borrowing paid off exactly.
But if the FTSE 100 index rose, the borrowing would be extended and more equities would be bought. If the option became deeply in-the-money (and so almost certain to pay out) then it would become a large holding of equities paid for by a large debt. The option payoff would be provided by the value of the equities minus the stable amount of debt.
For a five-year at-the-money forward option, the borrowing/equity split could be approximately 250% /+350%, so we could, instead of talking about options, ask the investor two questions: ‘Do you want to want to:
– invest in cash (30% [see note 1”) and equities (70% [see note 2”); and
– sell equities as the price falls, and buy equities as the price rises?’
The trading strategy is therefore to ‘buy high, sell low’, so it is expensive!
Despite that, the investor may really want such a package. There are perfectly good reasons to buy options. Insurance policies on houses are non-tradable options. Most of the time they expire worthless, but after a catastrophe, they finance a new house.

Marketability
Once investors have bought the guaranteed equity bond, they can’t sell it in the secondhand market, unlike the underlying assets.

Tax
Some of the brochures for these bonds argue that gain on the bonds will be subject to capital gains tax rather than income tax, and this may make them more attractive than the equivalent holdings of a bond and an option. But the tax-advantage argument may be a red herring. Capital gains are only tax-free on qualifying bonds, and capital gains tax allowances may already have been taken up.
Guaranteed equity bonds are, tax aside, equivalent to non-tradable deposits plus call options. They are marketed to appeal to risk-averse investors but these same investors might consider options ‘too risky’.
Investors who do like the idea should check carefully whether they are being offered a ‘plan’ which is ‘designed to’ achieve a certain payout, or a bond that guarantees, assuming the provider doesn’t go bust, a specified amount of money. o

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