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Base Rate Rise Looming? : Impact on Structured Products

Colin Mclachlan, Lowes Financial Management

Points of note:

  • The current 0.25% is a long way from the 17% base rate in the early 1980’s
  • The last time the base rate was increased was back in July 2007
  • After more than 7 years of a record low of 0.5% the base rate was halved again to 0.25% in August 2016 to support the economy after the Brexit referendum

On Thursday 13th September 2017, the Monetary Policy Committee, of the Bank of England, met to cast judgement on a potential interest rate rise. Two members of the committee considered an increase in the base rate by 0.25% appropriate, the remaining seven members didn’t feel a rise was necessary. However, the Bank of England has since announced that the base rate may have to rise to combat inflation, which is being pushed higher by the increasing price of clothing and motor fuels.

On the back of the announcement by the Bank of England, Sterling rose against the dollar, pushing the currency to levels last seen days after the Brexit referendum. The strengthening currency caused the FTSE 100 to tumble and this is due to the perceived impact on future earnings of the FTSE 100 listed companies.

Although an interest rate increase would be welcomed by savers, it would negatively impact those with variable rate mortgages, pushing monthly payments higher. So how would an increase effect investors looking to invest in structured products?

Whilst to the end investor a structured product is a packaged contract with typically simple, defined outcomes the behind-the-scenes makeup of investment consists of several elements. There are a number of variations on the theme but in simple terms the investment will be manufactured with a loan note / zero coupon bond, put and call options.

Zero Coupon Bond – This is the element that will provide for the repayment of capital at maturity. A discounted amount of money is invested per £100 required at maturity. The extent of the discount will be determined by the bank’s funding rate. So if the funding rate is 3% over six years then £83.75 needs to be invested at outset to provide £100 at maturity when the interest is added.

As interest rates rise, so should the bank’s funding rate and the price of the zero coupon bond / discounted investment amount will fall. So a funding rate rise to 3.5% means that the amount that needs to be invested at outset, to provide £100 at the end of six years falls to £81.35 leaving an extra £2.4 to buy market growth potential and provide upside.

Call Options – This element provided the growth potential within the structured product. Instead of investing in the market the options provide for potential participation in the upside of the market / underlying asset. The amount that needs to be invested in an option is much lower than the amount needed to own the asset. To appreciate the impact interest rates play in this scenario, we need to consider the capital that would otherwise be invested in the market instead of the option. Option buyers are willing to pay more for call options when rates go up as they will earn more interest on the difference in capital required.

So an increase in interest rates can make call options more expensive and as such, potentially, negatively impact the defined returns that can be offered by a structured product.

Put Options – This element puts the capital at risk at maturity. The option premium brings money ‘into the product’ at outset to utilise to acquire more growth potential. Put options offer similar exposure to shorting the underlying asset i.e. selling the asset without actually owning it, with a view to buying it later to cover the sale. As a short seller will have cash to deposit, an interest rate rise will have a positive impact on the cash. Therefore, buyers of put options can be expected to be willing to pay less for them when rates rise as they could have earned more interest by shorting the underlying asset instead.

Therefore, should UK interest rates rise, we should see the price of zero coupon bonds, and therefore the cost of capital protection, fall. This gives them more to spend on upside exposure. The cost of the call options providing that upside could however, also rise slightly whilst the premium commanded from the selling of the put option will fall, giving slightly less to buy upside.

The biggest impact of a rate rise is, however, on the zero coupon bond and as such, if all other factors are equal, a rise in interest rates should result in an improvement in the defined returns offered by the structured products subsequently launched.

You can however be certain that all other factors will not be equal and there are many others that also have an impact on the pricing of the product. Any one of these other factors could negate or magnify the short-term impact of a change to base rate.

Whether or not a rate rise occurs this year is, in reality, anyone’s guess but either way you can be certain that the structured product providers will continue to keenly price the best contracts they can, in what is now an appropriately competitive sector.