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Decrement indices – the next big innovation for structured products?



Investec Bank plc (the biggest retail structured product issuer in the UK) stopped issuing new structured products to retail investors in April 2021. To understand the impact on both providers and investors, I spoke with financial advisors, banks, plan managers, distributors and data providers. I was also able to conduct simple polls on LinkedIn which were reported in April’s Tricio Monthly Insights (please contact me if you would like to see a copy).


As I pointed out in the April Tricio Monthly Insights, inflow to structured products in the UK has been going down in recent years. The industry members said that was due to pressure on headline rates. But they also pointed to issues over dividend risk, after many companies abruptly cut dividend payments last year. Are decrement indices the answer?


Headline rates under pressure

Interest rates were low even before Covid-19. They dropped further in 2020 due to the pandemic. Though longer dated bond yields in the UK, US and other major markets have gone up in last few months, they remain lower than their pre-COVID levels. With option volatility remaining low as well, it is difficult to come up with structured products with headline rates that are comparable to pre-COVID times unless investors accept lower levels of protection or a lower likelihood of getting a return. Banks and providers told me that the pressure on headline rates is affecting reinvestments from matured structured products.


The second reason is more technical. When banks issue structured products linked to stock market indices or individual stocks, their trading desks take on dividend risk. This risk is not easy to manage for long dated products and sometimes involves taking a view on the dividend trend (for example, by assuming that the historical average dividend yield will continue). The COVID-19 economic shock affected the dividend payment of many companies. Some companies reduced or even suspended dividend payments, either voluntarily or were forced by the authorities to do this. In the UK, the Bank of England stopped UK banks from paying dividends last year. Such unexpected cuts in dividends caused some bank structured product trading desks to suffer losses. As a result, banks have become less willing to take dividend risk on their trading books.


What does that mean to investors? It means that investors need to pay a higher “hedging premium” to the bank if they want a structured product linked to traditional stock market indices like FTSE 100 and EuroSTOXX 50. This will affect product terms even more.


Introducing the decrement indices

An alternative for stock market index structured products is for investors to take the dividend risk. Standard benchmark stock market indices are calculated based on the actual dividend yield of the component stocks. Instead, banks and index providers can create variations by assuming a fixed dividend yield when calculating the index level. These “decrement indices” have been quite popular in continental Europe. We are starting to see more of these decrement indices being used in the UK.


Banks and providers argue that decrement indices are a good alternative for two reasons. First, the returns of decrement indices have a near 99% correlation with their corresponding standard benchmark indices. Secondly, for many popular structured product strategies like “autocalls” (or kick outs), you only need the underlying asset level to stay flat to produce a good outcome. As decrement indices have such a high correlation with the standard benchmark, as long as the benchmark indices, at worst, stay flat over the investment period, you should have a high chance of getting a return anyway. By taking the dividend risk that you normally would not take with traditional benchmark indices, you are compensated with a higher headline rate.


An innovation for the banks or for end investors?

But a few market participants whom I spoke with have another view. While they agree that innovations are needed to keep the structured product market growing, decrement indices have been created mainly to address the risk management needs of the banks rather than trying to meet actual investment needs. On one hand, it is important to keep delivering products that represent value for money to end investors. On the other hand, some financial advisers questioned whether end investors understand the risk they are taking to get better terms. They think banks will resume taking dividend risk when companies resume their usual dividend payments as global economies recover. End investors may be better off waiting for improvements in the pricing of structured products on more traditional stock market indices.


We do not dispute that in the current pricing environment, decrement indices provide an alternative that improves product headline rates, which in turn leads to better results in the “value for money” test (as required under the Priips regulations). However, the prescriptive framework used in the test does not capture or explain the dividend yield assumption risk to end investors. The test results on products that use decrement indices should be interpreted by noting such limitations.


I have seen many significant innovations in structured products over the last 20+ years. These include packaging structured products in tax free wrappers, “CGT notes” programs that allow returns of a structured note to be taxed as capital gains rather than income, and the introduction of kick-out strategies. All of these innovations align the interests of the key stakeholders in structured products: banks, distributors, advisers and end investors. When such alignment happens, we see growth in the structured product market, mainly because the end investors and advisers understand how such innovations create value to their portfolios. We will be keen to see whether decrement indices will be the next innovation that aligns all stakeholders and revives the growth of the structured product market in the UK.


James Chu CFA

Head of Investment Solutions

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