Betting on stability

Stability notes - products that allow betting against market crashes or fund implosions - are finding favour among high-net-worth investors. Hardeep Dhillon reports

Stability notes, also known as market default obligations, have been steadily growing as investment vehicles for the past few years, with most transactions largely structured on classic liquid underlyings such as the Standard & Poor's or Eurostoxx equity indexes. These equity-based notes experienced a surge in popularity between 2004 and 2005, as they provided investors with a payout in the region of 150-200 basis points above Libor. Transactions contained leverage of up to 10 times.

Effectively, investors in the notes would take on the risk that there would not be a daily drop of 20% in the value of the index, or whatever strike price was designated. The capital would be secure if the market fell by less than 20% but would start to erode if it fell by more. A 25% drop would leave the investor nursing a 50% cut in his capital, as he would be subject to the additional five points of loss multiplied by the leverage ratio - in this case, 10 times. And if the market fell by 30%, this additional 10-point loss would wipe out all his capital.

The deals were especially popular among private banking clients, who see them as a money market alternative. Legend has it that one distributor is understood to have sold as much as EUR2 billion worth of notes a few years back. "Stability notes look very safe, because a 20% drop in one day is not something that has happened much, if at all," says Kim Gayer, global head of structured equity sales at Deutsche Bank in London.

Bankers judge the total size of the stability note market - which is dominated by equity-linked notes - to be between $1 billion and $4 billion, although true volumes are hard to gauge, as there are no publicly listed figures. Deals are done on an ad hoc basis - chiefly private-placement and over-the-counter trades - so it is not easy to determine the exact number and size of transactions being structured. Antti Suhonen, head of fund-linked derivatives structuring at Barclays Capital in London, says: "The market is OTC, so deals are not done in the public domain. Also, the market is not particularly liquid, so it's hard to make generalisations about the product's development."

Now the stability note market is maturing to include other types of asset underlying, with investment banks tailoring products based on commodity and hedge fund indexes. Since the turn of the year, several banks have also seen demand increase for single-name hedge fund or fund-of-fund-linked stability notes. Hedge fund-linked stability notes allow the banks to pass on risks they are taking from the increased demand for geared or capital-guaranteed products linked to hedge funds.

Deutsche Bank's Gayer says there has been a surge in highly leveraged constant proportion portfolio insurance-based transactions as clients look to other assets classes to achieve higher returns. "The hedge funds and funds businesses have picked up quite a lot over the past several months," he says. "This growth is very much linked to the healthy returns that the asset class is offering at the moment and the fact that people have a lot of money to invest." Deutsche Bank's own hedge fund-linked stability note business is growing at a steady rate of between 50% and 60% year on year, adds Gayer.

Richard Burns, Citi's New York-based global head of hybrid products, says: "There have been a number of trades done, because there is natural demand from a wide of range of investors that want long principal-protected, hedge fund-linked products."

Typically, deal size ranges between EUR20 million and EUR50 million, with some tranches as large as EUR100 million. The investor base consists largely of private banking clients, but also includes banks, high-net-worth individuals, a number of hedge funds and corporates, and some demand from institutional clients.

Distribution is still mainly European, but there is strong interest from Asia. For instance, a number of corporates in Japan with excess cash are looking to invest in products offering extra yield on account of low yen interest rates, say sources. There is scant activity in the US, due in part to restrictive regulations and the fact that investors might prefer to participate in the upside by investing directly in the funds.

Admittedly, another Amaranth-type blow-up would reduce interest in the notes. But right now, some banks are seeing healthy demand for them. Bankers say a wider range of investors is looking at the product than previously, with many stepping into the market for the first time, such as the occasional institutional investor and a growing number of high-net-worth clients.

Interest from the institutional community is still negligible, though, as many are put off from buying stability notes by real or perceived documentation arbitrage. As the product's payout is linked to something that could possibly be considered as a disruption event, says Deutsche Bank's Gayer, investors do not want to risk losing capital due to a legal technicality and from not fully understanding the documentation. Citi's Burns agrees. "You have to be up to speed because it is critical to understand the product; it is suitable for some investors, not all," he says.

Typical returns

Stability notes on hedge fund underlyings typically offer returns between Libor plus 200bp and 300bp and are usually leveraged five times. While equity-based products are based on daily moves in price, the valuation points for hedge funds or funds of funds occur either monthly or quarterly. It is not always obvious from the face value of the note what amount of cover the structure is providing, as stability notes are geared structures, and an issue of $100 million could be covering $300 million to $500 million of risk.

The aim of stability notes is to allow investment banks to hedge the risks they have built up in their books as a result of issuing CPPI-based structured products to investors. By selling capital-guaranteed notes on the more illiquid assets such as hedge funds, banks end up with a gap risk, says Citi's Burns. For instance, should the value of the asset drop by more than the designated strike of, say, 25% between two valuation points, the bank finds itself short on its trading book for the amount below the 25% gap. "The gap effect in your hedging strategy is an out-of-the-money, bullet binary event," says Burns.

Another structure allows the investor to borrow more money and invest in the underlying assets if they appreciate in value. The important part of this structure is that every time the asset drops in value, some of the asset is sold off, and bonds are bought to maintain a 25% gap on what the asset is doing. "You delever/lever according to a set of predefined rules to manage the balance between how much is in cash and how much is in the asset," says Burns.

Movements greater than the 25% gap on banks' balance sheets do expose them to risk, but banks do not typically assume the market will drop from 100 to zero and so feel no need to cover the entire gap. For instance, banks could assume a worse-case scenario of 40%, so only need to take on cover from 25% to 40%.

To do this and make the yield attractive for a high-net-worth buyer, investment banks often include a put spread in the note and lever it between three to five times. So, for example, a bank buys a 75/60 put spread to cover the extra 15 points of loss on the notes, so in the event the value dropped to between 75 and 60, the put spread would pay out. This is then leveraged up - say, five times - so if the notes trigger at 70, the five points of loss would result in 25 points of loss on the security for the investor. Effectively, investors will lose their capital at a ratio of five to one.

Equally, the investor receives five times the value of the put spread in additional yield. For example, a put spread worth 20bp a year would give investors an extra 1% on top of the Libor spread that most notes provide. Deals are typically structured more on an 80/60 ratio and levered five times, so investors face the risk of losing all their capital if there were to be a knockout.

"High-net-worth individuals would take a look at this and might feel it is a highly unlikely scenario and an out-of-the-money risk, as they may think hedge funds will not drop by more than 25%," says Burns. "Investors would therefore view stability notes as paying attractively for a risk they do not think exists."

Deutsche Bank's Gayer notes a recent pick-up in selling hedge fund gap risk as a result of increased demand and a greater need for banks to hedge themselves through stability note issuance. "We see ourselves as a transformer of risk," he says. "We do not want to keep that risk on our books forever, and the stability note is one of the ways to offload that risk."

But some banks are comfortable keeping the gap risk on their books because they have strong risk budgeting. A structurer at one Swiss bank says his institution has not undertaken a stability note trade on hedge funds for almost three years. "We didn't see the need to get rid of that risk," says Gayer. "We have a strong balance sheet and no need for stability note products to hedge the 'crash' risk. Banks get paid a hefty premium to take this on, so why would they pay a premium to someone else take the risk away?"

The structurer adds that stability notes are merely a good hedge rather than a perfect one, and do not effectively address the delta on bank's balance sheets. Also, many hedge funds that are willing to undertake crash risk trades prefer to do so in the form of swaps rather than use the stability note format. Nonetheless, he acknowledges that the products make more sense if banks have a lot of single-name exposure. "If banks have a fantastic hedge fund franchise and get paid a premium for it, some may not mind paying away some of that premium to continue to tap these transactions and alleviate single-name risk," he says.

Sophistication

Barclays Capital's Suhonen reports some interest in hedge fund stability notes, but says that for some clients the products are a difficult underlying to consider. "Investor demand has focused on the traditional underlyings, such as equity, and the number of clients that are willing to consider hedge fund stability notes is a much smaller population because of the perceived additional complexity of the underlying," he says.

The stability note is a product for fairly sophisticated investors, adds Suhonen, and banks have to be very careful when dealing with these counterparties to ensure they really understand the risks inherent in the product. "An essential part of the equation is understanding the inherent leverage in these products and the rate at which your capital could erode if something unexpected happens," he says.

Admittedly, all participating banks in the hedge fund structured products business stand to benefit from trying to structure deals to cover their own hedge fund gap risk. But Mike Vitelli, head of fund derivatives trading at BNP Paribas in New York, says that as long as there are investors interested in stability notes, banks might as well go ahead and structure transactions. "The banks have found a niche and found some investors that are attracted to the returns and accept the risk, at a price that makes sense for the banks," he says. Another banker agrees: "As long as the investor feels comfortable, the products will continue to sell well," he says. But such blase attitudes could, of course, come back to haunt stability note issuers in the event that an investor feels the product was mis-sold.