SINGAPORE investors have taken to structured products in the past few years, with those offering capital protection becoming popular in the wake of volatile equity markets. Structured deposits are the most common form of capital guaranteed structured products available to retail investors in Singapore. They generally consist of a conventional fixed deposit combined with derivative instruments on one or more assets (equities, interest rates, bonds, currencies and commodities).

The principal of a structured deposit must be guaranteed by the deposit-taking institution on its maturity, while the interest payable depends on the performance of the product's underlying assets. It is also common for structured deposits to have some minimum guaranteed interest. Structured deposits launched in Singapore are usually linked to interest rates or equity. We look at some common features of structured deposits and how they work:

Callable: The bank may 'call' (redeem) the structured deposit at its discretion. When this happens, the depositor will receive the principal amount and/or accrued interest up to such date.

Autocall: The bank will automatically 'call' (redeem) the structured deposit when the underlying assets reach a pre-specified level.

Target redemption: The bank will redeem the structured deposit when the aggregate interest paid equals to or exceeds a target amount. Usually, a high guaranteed interest is paid within the first few interest periods, and only a small amount of variable interest is needed to reach the target amount. The probability of reaching the target amount depends on the performance of the underlying assets. Another version is a target redemption structure for the bank to redeem the structured deposit when any (not aggregate) variable interest paid equals to or exceeds a target amount.

The following are popular interest rate-linked structured deposits.

Callable step up: Interest is fixed for each interest period at an increasing rate. The bank can call back the structured deposit at its discretion.

Advantage: Interest rates are fixed and are usually higher than current fixed deposit rates.

Disadvantage: If the bank calls back the structured deposit, the prevailing interest rates will be lower and depositors will face reinvestment at lower rates.

Range accrual: Interest is accrued on a daily basis if the benchmark interest rate stays within a pre-specified range. This type of structured deposit usually includes a callable feature.

Advantage: Depositors receive higher interest if the benchmark interest rate stays within range.

Disadvantage: Depositors receive no interest if the benchmark interest rate is out of range. As benchmark interest rates are often used as a policy tool by central banks, once the rate moves out of range, it may take many years before it returns to current levels.

Inverse floater: Interest payable is determined by a formula and is inversely proportional to the benchmark interest rate. If the benchmark interest rate moves above a certain level, no interest will be payable. This type of structured deposit usually includes a target redemption feature.

Advantage: Depositors receive higher interest if the benchmark interest rate stays below a certain level.

Disadvantage: Depositors receive no interest if the benchmark interest rate is above a certain level. For those including a target redemption feature, the maximum tenor can be as long as 10 years.

For structured deposits linked to equity, there are no fixed classifications. Typically, interest payable is based on the performance of the selected equity. Depending on the structure, interest may be paid when the performance of the selected equity is positive or negative. Selected equity may be a single share or a basket of shares. Some important factors to consider include:

Performance cap: A cap limits the maximum interest payable on the structured deposit. Where interest payable is dependent on the average performance of a basket of shares, it is common to have a cap on the average performance. It is also important to check if the cap is applied on individual shares, on the basket, or on the interest.

Downside buffer: A downside buffer provides some protection on the equity performance. With a downside buffer, there can still be interest payable even when the shares have negative performance (provided that the negative performance does not exceed the downside buffer). Having a downside buffer is especially important where interest payable is dependent on the performance of the worst performing share as the performance of the worst performing share is more likely to be negative.

Participation rate: This is the amount of exposure to the performance of the underlying assets. However, it is a misconception that a higher participation rate is better for depositors. If interest payable is dependent on the performance of the worst performing share and there is a downside buffer, a lower participation rate is more beneficial to depositors.

Diversification: Contrary to popular belief, having a diversified basket of shares may not be better for depositors. If interest payable is dependent on the worst performing share, having a diversified basket increases the probability of the worst performing share having negative performance, lowering the probability of interest being paid.

However, where interest payable is dependent on the best performing share or on the basket's performance (without a performance cap on individual shares), depositors will benefit from a diversified basket of shares.

Guaranteed interest: This is a common feature of structured deposits in Singapore. Having a guaranteed interest improves the worst case scenario but worsens the best case scenario for depositors. Since structured deposits are principal guaranteed, only the interest portion is invested into the underlying assets.

Incorporating a guaranteed interest effectively lowers the amount that can be used to invest into the underlying assets or to buy protection (downside buffer), hence reducing potential gains from the underlying assets.

Tenor: There is no optimal tenor for a structured deposit. Depending on the structure and the underlying assets, the tenor should be optimised for maximum benefits. Depositors usually prefer shorter tenor structured deposits. However, a shorter tenor means there is a smaller amount of interest to be invested into the underlying assets and may not benefit the depositors. In many cases where the structured deposit has a tenor of less than a year, depositors would be better off placing a conventional fixed deposit for the same tenor.

From 2001 to mid-2004 (see chart), with major central banks cutting interest rates, interest rate-linked structured products (where interest is payable if the benchmark interest rates stay below certain levels) were popular. However, from mid-2004 to 2006, the major central banks reversed their policy and started to hike interest rates. This led to poor performance from these products as the strategy was based on benchmark interest rates staying low or not rising too high.

Long-term interest rates have started to soften. This is in part due to many traders believing that the US interest rate hike has come to an end (see table) as the US Federal Reserve has held interest rates stable in the last two Federal Open Market Committee meetings. With interest rates possibly falling, it may be the best time to consider mid to long tenor structured deposits to lock in the rates.

With many equity markets and commodity prices at a high, it is also important to consider carefully the investment strategies and underlying assets of structured deposits. Depositors will reap the maximum benefits of a structured deposit if the investment strategy on the underlying assets is proven correct during the tenor. In uncertain market conditions, the more prudent investment strategies include a 'best-of' strategy on a diversified basket of assets or a 'relative performance' strategy with some downside buffer.

A word of caution: Structured deposits are generally less liquid than conventional funds, and depositors have to bear in mind that their principal is not guaranteed should they withdraw before maturity. So investors should only place idle money into structured deposits.

The writer is director, structured products group, United Overseas Bank

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» The alternative view
» Holistic approach to investing
» Diversifying into foreign currencies
» Greater accessibility for smaller investors
» Cashing in on en bloc fever
» A closer look at structured deposits
» Retirement dreams
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» Opportunity for greater gains

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