The “digital” or fixed return product type has seen an increase in popularity in 2020. There are many different variations and definitions in the market, but they generally consist of a fixed payment that is either paid or not, depending on a particular event linked to the reference underlying of the product.
The most frequent occurrence of the digital product type is in capital protected (often deposit) products. The simplest example is a product with payment of the investor’s capital at maturity and a fixed payment if the underlying is above the target level (usually the initial level) at maturity. If this does not occur, then capital only is repaid.
Capital protected solutions in the UK
In the UK retail market, the largest plan manager Investec has issued many digital products in recent years as part of their capital protected deposit range.
A recent product suite includes a six year product linked to the FTSE-100, where a return of 39% is paid if the FTSE-100 is up over the product term (as measured by a daily average over the final six months). If this does not happen, then capital only is paid.
The digital option is one of the simplest propositions, since it effectively asks the investor if they believe that the underlying will be up over the product term, and if so a fixed return will be paid in getting their “bet” right. It plays well with capital protected products since this return is added onto the capital repayment amount.
Comparisons to cash
Given that capital protected products are naturally compared to cash alternatives, it makes sense to look at the rate that can be earned against a cash rate. In the example above, the compounded return earned is around 5.6% per annum compared to cash rates of 1-2%. In common with most major indices, historically the FTSE-100 along has had a very high success rate of being up point to point over this horizon.
Another reason for the popularity of the digital product is that terms are relatively insensitive to changes in volatility, so it can be offered in different market conditions. It is true to say, however, that the headline rate is very roughly proportional to the combined level of interest rate and funding spread.
Investec have also issued other versions, such as a six year product that pays 9% fixed in all circumstances plus a further 9% digital payment if the FTSE-100 is above its start level. This mixing of fixed and digital return is another positioning against cash alternatives. The idea of the 9% is to match cash returns with this amount being doubled if the index is up.
A solution for shorter maturities
The digital product also works well for shorter maturities, where any participation based growth return is very hard to achieve. Two such examples are one that pays 9% for a three year product if the FTSE-100 is above 90% of its start level, and a second that pays 13% if the index is above 100% of its start level, both products using a six month average calculation. This equates to 2.9% and 4.1% respectively. The 90% version is a lower risk product designed to increase chances of the digital return being paid because over a three year horizon markets are less sure of showing a positive return.
Other issuers have also employed this product type, for example Santander in the UK pays 11% in four years if the FTSE-100 is up, and 0.25% if it is down over this period. For the offshore market, South African issuer Standard Bank also have a four year product that pays 14% if the S&P-500 is up, and 2% if not.
More complicated versions exist, such as one issued by Abanca in Spain. Linked to the worst performing of three stocks (Telefonica, Renault and Total), it pays a multiple digital return of 4.8%, 9.6% and 14.4% if the worst performer is above 100%, 110% or 120% of its start level respectively, again with a consolation 0.5% return on top of capital if this does not happen. Source for product data outside UK from www.structuredretailproducts.com.
It is also possible to combine digital payoffs on the upside with the usual barrier or buffer capital at risk construction, in order to enhance the digital return that can be paid compared to the capital protected version.
However, arguably, such complexities start to detract from the rationale and appeal of the digital product which at its heart is designed to have a simple underlying dependent payment on top of capital as an enhanced cash alternative.