Chinese investors turn to structured products

Investors from China's regional cities, tired of losing money on local stocks, are turning their attention to structured products in the hope that derivatives can help them beat the markets.

Chinese stocks have been losing value for the past 15 months – the H-share index in Hong Kong is down two-thirds from its peak in October 2007. During the run-up to that peak, investors in China had little interest in buying products with miserly single-digit coupons when they could get much bigger returns from investing in initial public offerings.

But investors are more open-minded now that returns are harder to come by. Stocks are a dead loss and bond yields, which enjoyed something of a bull-run in 2008, have been heading south since September.

Investment banks in Hong Kong and Singapore have been selling structures to China's big commercial banks for the past couple of years, but now even the smaller regional banks are starting to offer equity structured products. Bank of Ningbo is the latest example – it is currently marketing its first ever equity structured product to customers in Shanghai, Zhejiang, Jiangsu and neighbouring provinces in eastern China.

Ningbo asked international investment banks to pitch ideas that would provide absolute returns, a guaranteed coupon and principal protection, with a Hong Kong-listed A-share exchange-traded fund as the underlying asset. The note itself, however, needed to be sold in renminbi, requiring it to be quantoed from Hong Kong dollars.

RBS won the mandate with a product that hits all the right notes. The one-year structure pays a coupon between 2.5% and 10% so long as the ETF's price is no more than 20% above or below the starting price on any of the 12 monthly valuation dates. There is also a get-out-of-jail-free feature that allows the ETF to trade outside of the range on one of these valuation dates and still pay a 2.5% coupon at maturity, so long as it stays within 30% of the starting price until maturity.

If the ETF trades within the range, the structure gives a 50% participation in the price movement on the final valuation date. In other words, if the fund trades up or down 20%, the investors get paid 10% -- with a guaranteed minimum coupon of 2.5%. If the fund trades outside the range, investors still get their principal back, plus a guaranteed coupon of 0.36%

A coupon of 2.5% or more compares favourably with the return on risk-free investments. The benchmark one-year deposit rate in China is now down to 2.25% and China International Capital Corp predicts there will be a further 81bp rate cut by mid-2009.

The key, of course, is whether the outlook for Chinese equities will allow structures such as these to pay out. Volatility on the A-share ETF spiked in September and October but is now back to more stable levels – 30-day vol is down from 125 at the end of October to around 40 now, and the fund has traded within the plus-or-minus 20% trading range for the past three months.