Of course, both types of protection are subject to counter-party risk, and much has been talked about that topic in the past.
Here we look at the difference between the two types of soft protection available, and explain how each type affects investors.
We will also look at some historical analysis to see exactly how effective each type of soft protection has been over time.
Soft-protected products return investors’ capital in full at maturity, provided the underlying asset does not fall below a pre-determined barrier.
This barrier is usually observed either daily throughout the investment term, which is called the "American barrier", or on the maturity date only, or the "European barrier".
If the barrier is breached, investors’ return of capital at maturity will reflect any negative performance of the underlying asset on a 1:1 basis.
As the American barrier could potentially be breached daily throughout the term, it is a higher-risk investment compared with the European version – and therefore the potential return for a structured product with an American barrier is likely to be higher than a structured product with a European barrier, all else being equal.
Our analysis looking at how often a range of soft-protection barriers would have been breached for a six-year investment linked to the FTSE 100 index shows that if we take daily rolling six-year periods since the inception of the FTSE 100 in January 1984, we get 5,798 observation periods.
Therefore, if a six-year product had been launched every day since then, there would be 5,798 products, with the last one issued on 14 November 2006, maturing on 14 November 2012.
For American barriers we also observed the periods from 15 November 2006 with less than six years left until maturity, giving a further 1,516 observation periods, to 14 November 2012, bringing the total to a whopping 7,314 observation periods since the inception of the FTSE 100.
Soft-protection barriers, based on rolling 6-yr maturity dates since FTSE’s inception
| Barrier | Barrier Type | Proportion of observations barrier breached | Proportion of observations capital lost | Average loss when barrier breached | Maximum loss when barrier breached |
|---|---|---|---|---|---|
| 50% of initial level | European | 0% | 0% | n/a | n/a |
| American | 0.77% | 0.77% | 15.58% | 27.41% | |
| 60% of initial level | European | 0% | 0% | n/a | n/a |
| American | 17.90% | 15.83% | 10.68% | 29.77% | |
| 70% of initial level | European | 0% | 0% | n/a | n/a |
| American | 29.87% | 20.60% | 7.93% | 29.77% | |
| 75% of initial level | European | 1.05% | 1.05% | 26.46% | 29.77% |
| American | 33.31% | 21.22% | 7.35% | 29.77% |
Source: Morgan Stanley
Based on this data, a 50 per cent European barrier observed at maturity only has never been breached. The maximum the FTSE 100 has lost over any six-year term is 29.77 per cent over the period.
For American barriers, it is important to note the difference between the columns showing the proportion of observations the barrier is breached and the proportion that capital is lost.
If we look at the 60 per cent barrier as an example, the barrier was breached 17.9 per cent of the time, but capital was only lost in 15.83 per cent of cases.
The difference is accounted for by the fact that the FTSE 100 index might breach the barrier during the term, but recovers to be above its initial level at maturity. In these cases, investors receive the repayment of their capital in full, in addition to any advertised growth or income.
For investors who take the view that equity markets will not fall by more than a certain amount over a specific investment horizon, soft-protected products offer an attractive option, and American barrier soft protection provides an additional boost for slightly more risk-tolerant investors.
It pays to remember that a 50 per cent barrier still means that the underlying asset has to fall by half before any capital is at risk, so it therefore provides much more capital protection than many other investment vehicles.
Nev Godley is a vice president at Morgan Stanley. The views expressed here are his own.