Institutional investors traditionally gain exposure to equities and bonds by purchasing the underlying securities directly. While this approach remains central to portfolio construction, direct investment can sometimes present practical constraints, particularly when investors seek exposure to assets listed or issued outside their domestic markets.
Derivatives can provide an alternative route. When combined with traditional deposits, they can create structured solutions whose returns are linked to the performance of equities, market indices, corporate debt or sovereign credit. These structures allow investors to gain exposure to selected markets without necessarily purchasing or holding the underlying securities directly.
Equity-Linked Deposits and Credit-Linked Deposits illustrate how this can be achieved. Both can expand the investment opportunities available to institutional investors and provide additional sources of return. However, their use introduces risks that must be carefully assessed, including the performance of the referenced asset and the creditworthiness of the institution providing the investment solution.
Equity-linked deposits
Let us examine Equity-Linked Deposits. These are investment vehicles that track assets beyond traditional fixed income, such as equities. They are becoming increasingly common in the region, particularly in East and Southern Africa, where institutional clients seek returns associated with the performance of equity markets and equity derivatives.
Generally, these products combine a deposit with an equity call option. The return enhancement is derived from the performance of the call option acquired by the investor. The option may reference the shares of a single company, an equity index or a basket of equities, such as the MSCI World Index or the S&P 500 Index.
The investor places funds in the deposit and receives the principal at maturity, subject to the terms of the structure and the creditworthiness of the issuing institution. The call option provides the potential for an additional return if the referenced equity or index performs favourably over the investment period.
This structure allows investors to participate in equity market performance without purchasing the underlying shares directly. It may therefore appeal to investors seeking exposure to international equities while retaining a deposit-based investment structure.
The solution can also be customised to reflect the investor’s preferred market exposure, investment horizon and return objectives. An investor may select a single equity where there is a specific market view or choose a broad index or basket to diversify exposure across several companies, sectors or markets.
Furthermore, by using a cross-currency swap as an overlay, the structure can be converted into payouts in the local currency. This can allow the investor to receive returns in a currency aligned with its liabilities or investment requirements. Depending on market conditions and the design of the structure, the currency component may also contribute to the overall yield enhancement.
As with the other derivative-based investment strategies discussed in this series, counterparty credit risk remains an important consideration. The investor relies on the institution offering the solution, often a bank, to fulfil its payment obligations. The creditworthiness of the issuer must therefore be considered alongside the potential performance of the referenced equity or index.
Credit-linked deposits
Another yield-enhancement strategy is the Credit-Linked Deposit. This product may be particularly relevant to investors in our region because of their familiarity with government and corporate bonds.
A Credit-Linked Deposit allows an investor to gain exposure to a sovereign or major corporation without holding the underlying security directly. It can provide customised coupon payments similar to those that the investor might receive from owning the referenced bond.
The structure can be created by combining a deposit with a Credit Default Swap, thereby creating a funded credit exposure. The investor selects a reference entity based on its risk appetite and receives a corresponding return. A reference entity with a lower perceived probability of default would generally offer a smaller coupon, while exposure to a higher-risk name may provide a larger coupon to compensate for the additional credit risk.
The payment profile can also be customised. Instead of receiving the semi-annual coupon payments commonly associated with bonds, for example, an investor may structure the Credit-Linked Deposit to make quarterly payments. This flexibility can assist institutional investors in managing cash flows and matching investment income against expected liabilities.
A distinctive feature of the Credit-Linked Deposit is that it removes the need for the investor to purchase the referenced bond or open a securities depository account in the issuer’s country. This may reduce administrative requirements and eliminate some of the custody or depositary fees associated with direct ownership.
For illustration, an investor in Ghana seeking exposure to the Kenyan sovereign could obtain that exposure without establishing accounts or a securities depository arrangement in Kenya. Instead, the investor could engage a suitable counterparty, preferably a bank, place an amount corresponding to the desired sovereign exposure and enter into a credit derivative referencing that sovereign.
Under this arrangement, the investor obtains synthetic exposure to the referenced sovereign. The deposit and the credit component together generate the return sought by the investor.
The structure does not eliminate credit risk. If a credit event occurs in relation to the referenced entity, the investor may lose part or all of the amount invested, depending on the terms of the product and the recovery value of the referenced obligation. Since the Credit-Linked Deposit is an over-the-counter structure, the investor is also exposed to the creditworthiness of the counterparty with which the transaction is executed.
If that counterparty becomes insolvent or is otherwise unable to meet its obligations, the investor may suffer a loss independently of the performance of the referenced sovereign or corporation. Investors must therefore assess both the reference entity and the institution providing the structure.
Regulatory considerations and market opportunity
Implementing these yield-enhancement strategies requires careful consideration of the applicable local regulations. Certain structures may fall within the alternative investment provisions under the Guidelines for Asset Managers and the Guidelines on Investment of Tier 2 and Tier 3 Pension Scheme Funds.
Where a structure provides exposure to an asset or reference entity outside Ghana, it may also be treated as an external investment. Investors must therefore consider the applicable asset-allocation limits, approval requirements and foreign-currency rules before entering into a transaction.
The foreign-currency component of these investments may require compliance with guidance issued by the Bank of Ghana. Pension funds, asset managers and other institutional investors must also ensure that any proposed investment is permitted under their governing mandates and internal investment policies.
These requirements do not remove the potential value of the structures. They establish the conditions within which the investments must be assessed and implemented. Regulatory limits can restrict the proportion of a portfolio allocated to external or alternative investments, thereby containing the overall exposure of a fund to these instruments.
For asset managers, pension funds and corporates, the potential opportunity lies in using permitted allocations more effectively to achieve diversification and pursue enhanced returns. Equity-Linked Deposits can provide access to international equity performance, while Credit-Linked Deposits can provide exposure to sovereign or corporate credit without requiring direct ownership of the referenced securities.
Cash flows generated by these investments, including coupons or investment proceeds, may eventually be repatriated and converted into local currency. Investors must therefore consider not only the prospective return but also currency movements, repatriation requirements and the effect of the investment on their regulatory asset-allocation limits.
A depreciation of the local currency, for instance, may increase the local-currency value of a foreign-currency investment and affect the proportion of the portfolio allocated to external assets. The investor may consequently need to rebalance the portfolio to remain within the applicable limits.
The suitability of these solutions will depend on each investor’s mandate, risk appetite, liquidity requirements and capacity to evaluate structured investments. Their adoption must therefore be supported by appropriate governance, transparent documentation and a clear understanding of the underlying market and credit exposures.
Conclusion
Derivatives are widely used to manage market risk, but their application extends beyond hedging. Equity-Linked Deposits and Credit-Linked Deposits demonstrate how derivative-based structures can help institutional investors access new markets, diversify their portfolios and pursue additional returns without necessarily purchasing the underlying securities directly.
These benefits must be considered alongside the relevant risks. Equity-linked structures depend on the performance of the referenced shares or indices, while Credit-Linked Deposits expose investors to the credit risk of the reference entity. Both also create exposure to the institution providing the investment solution.
The development of these products will require engagement among investors, financial institutions and regulators. Investors need sufficient expertise and governance arrangements to evaluate the structures, while providers must ensure that the products are transparent, suitable and properly understood. Regulators also have an important role in establishing the conditions under which innovation can take place without compromising the protection of investors or the stability of the market.
Used within appropriate regulatory and investment limits, structured solutions can broaden the range of opportunities available to local institutional investors and contribute to the continued development of Ghana’s financial market.
By Gerald Nana Kusi
The writer is Head, Institutional Sales and Structuring, Absa Bank Ghana LTD
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