The cliquet payoff
Many investors need long term solutions for capital growth or income with controlled risk. This is particularly true for investors seeking retirement solutions having built up a portfolio over time. The typical profile is someone ten to fifteen years from retirement seeking to extract some further gains from their portfolio but turning their focus to income generation and capital preservation.
The fund management world and those using a broker or platform for self investment have adopted a number of trusted approaches for many years. These include reducing risk levels over time (such as the “age in bonds rule” which advocates 1% of your portfolio in bonds per year of your age, eg 55% at age 55) or following 60/40 splits in favour of equities in the build-up phase and reducing risk much later.
Structured product solutions for retirement
Structured products are clearly well positioned to address this goal because of their defined returns, emphasis on income or targeted growth and risk control. Most structured products tend to be three to six years in length depending on the preferences of the market they are issued in. This maturity range is particularly true of capital at risk products because that length generally gives the best trade off in terms of yield, upside and risk. Beyond this horizon the necessary index or stock options to help the hedging process are less liquid, particularly those linked to single stocks. This will result in fewer banks willing to quote for longer dated products and product terms reduced because of the increased risk reserving that will take place.
Longer maturities make particular sense for capital protected products because they can give more upside in exchange for the interest given up and the credit risk taken on. While simple participation products have been seen in many cases there are various problems to contend with. One is that writing long dated options has a lot of risk for banks caused by long term dividend and volatility assumptions. There is also the question of likely performance and future returns. If a product is offered with ten or more years full capital protection it is highly debatable that this is a sensible allocation of funds for the investor. Even if the protection is priced fairly the investor has to take the view as to whether it makes sense and fits their views over the long term.
Introducing the cliquet
As an alternative product, the “cliquet” payoff has been familiar for many years. Its enticing name shows its roots from the French market (being the French word for “ratchet”) and was first seen over twenty years ago. The cliquet divides the full term of say six years into equal periods (for example one year). Performance is then measured year on year and compared to pre-determined maximum and minimum levels (cap and floor). This gives rise to an annual payment which can either be paid out or rolled up to maturity and subject to a further maximum or minimum overall value.
This payoff does have some appeal since it ties product returns to what happens in each period. It does reduce exposure on long term volatility and dividends. However, it creates more subtle risks, for example to “forward” volatility, that is the expectation of the level of one year volatility at different points in the future. The cliquet is also extremely hard to price and risk manage and is very sensitive to the modelling approach that the bank may employ (stochastic volatility versus local volatility for example). There have been many cases over the years of over-aggressive pricing strategies and mis-pricing due to “model risk” (the incorrect choice of a model that would be perfectly acceptable in another setting).
Usage despite falling out of favour
Cliquets remain popular in some markets today. These include Belgium, France and the Czech Republic. In France and Belgium the typical structure has a cap and floor each year, for example a cap of 5% return and minimum of zero. In the Czech Republic the cliquet has also been seen in the FX market.
It is fair to say that the cliquet is not as popular as it once was. This is due to a number of factors, including a return to more simple payoffs driven mostly by regulatory pressure. The pricing of cliquets has also proven troublesome and the logic behind such a smoothing operation of returns is less compelling with low volatility indices and ETFs now commonplace.
The other market where the cliquet remains a regular choice is the US. They have been used in the Certificates of Deposit (CD) sector where providing capital or income while maintaining capital preservation has proven challenging in low rate and high volatility environments.
Comparison with index-linked annuities
The US also has a thriving sister asset class to conventional structured products in the registered index-linked annuity market. These insurance investments sit alongside more traditional annuities as a way to look for enhanced returns at moderate risk. For this wrapper products are treated slightly differently and combine actuarial considerations with a hedge bought from an investment bank with a derivatives desk.
Conventional annuities accumulate at fixed rates each year and these vanilla versions were the first type of annuities sold. However as with most cash investments this concept has suffered enormously with falling swap rates and treasury yields. Indexed annuities first appeared around twenty years ago to provide better solutions, particularly aiming to generate decent returns in a low interest rate environment.
Annuity products are typically 7 to 10 years long and the original Indexed solutions were “lock-in” or point to point products over the whole term. These used both cliquet and participation payoffs, often with caps and averaging. This maturity range was too long for some investment banks and so Insurance companies suffer from a limited choice of issuers.
In recent years there has been a change of product type to an annual accumulation construction based on a certain index participation level or cap. For example the investor may get 50% participation to an Index or have an annual cap of 7% with 100% participation up to that level with the cap reset according to market rates in subsequent years.
This more flexible approach reduces the need for insurance companies and banks to commit to long term expensive hedges. The main disadvantage is not being able to advertise terms to the investor in advance over the long term.
In conclusion we acknowledge that the cliquet payoff provides a unique way to capture returns year on year for different use cases. However as markets evolve and pricing conditions and investment patterns change it seems that preference is shifting towards alternative solutions.
Tags: ValuationsImage courtesy of: Tekton / unsplash.com
