Italians love fixed income like nobody else – the country’s high-net-worth investors had as much as 27% of their portfolio in bonds in 2016, compared with 10% in Germany, 13% in the UK and 15% in the US, according to asset manager Legg Mason. Yet, the past year has seen the long-term love affair between Italian investors and the bond markets come to an end.
“In Italy there is a big savings culture and Italian asset managers are traditionally heavily skewed towards fixed income securities. But the persistently low interest rates in Europe have begun to dampen demand,” says Marco Tuninetti, a director in equity derivative sales at UBS. “The trend over the past 12 months has been to seek out diversification opportunities, and structured products have seen rising levels of demand from retail and institutional investors.”
Over the past 12 months, UBS’s structured products team has printed more notes tied to commodity underlyings, particularly in the exchange-traded space. It has seen a sharp rise in demand for multi-asset exposure and responded to increased interest from insurance companies for unit-linked and Solvency II-compliant equity exposure.
With the European Central Bank only recently starting to slow its programme of quantitative easing, interest rates have traded in negative territory or hovered near record lows over much of 2017. In response, the normally equity-shy Italian investment community has shown a greater willingness to ramp up their exposure to equities, in many cases leveraging the global low-volatility trend that saw the CBOE Volatility Index fall to a record low in July.
“We saw a lot of demand for notes that paid a coupon leveraged against the unlikely event of a sharp one-day move in equities,” says Tuninetti. “Over the past year, we worked with a number of private banks to deliver these solutions to their professional clients, who see the product as a cash alternative, linking notes to developed and emerging market indexes.”
The so-called stability notes were typically structured against the Euro Stoxx 50, with a maturity of between six and 12 months. Investors start to lose their capital if the one-day return on the index is below 10% during the life of the note. If there is no gap event, the note redeems at 100% of the coupon.
“We did an assessment of the risk/reward of these notes and it’s worth noting that in the past three years there have been several periods of significant equity market turbulence – during the European sovereign debt crisis, for example. But still, no kick-in events have occurred,” said Tuninetti.
The trend over the past 12 months has been to seek out diversification opportunitiesMarco Tuninetti, UBS
UBS has structured the notes with different gaps – some at 12%, for example – and recently sold notes with two- or three-day gap periods that aim to offer investors an additional uptick in returns. The bank has sold as much as €100 million ($117 million) of the notes to date.
UBS was able to make the stability note business work, despite the very low gap-event risk, because it runs a deep, widely distributed gap book, meaning it was able to buy the gap risk from structured note investors and sell it on to funds, usually located elsewhere in Europe.
Away from equities, risk premia strategies continued their recent surge in popularity over the past year, and UBS structuring teams did brisk business in single risk factor products and risk factor portfolios. The bank’s platform is comprised of strategies across equities, bonds, commodities and foreign exchange, with strategies designed to ensure the maximum possible transparency and daily liquidity. In one innovative trade, UBS structured an actively managed deal for an Italian asset manager in an unfunded swap format, which enabled the client to obtain two to three times leverage and sell ad hoc funds as a tactical overlay to its internal asset allocation model.
“This was the first [swap] transaction of its type in the Italian market,” said Tuninetti. “It was a basket of actively managed risk premia which offered the client diversification with a transparent methodology and all costs known upfront, and the mark-to-market only crystallised on a pre-established date.”
The swap was fully collateralised with daily margin in cash under a two-way credit support annex. UBS also used the swap format for a joint project with the chief investment office of its wealth management unit, which has a dedicated short-term investment opportunities team. Based on the team’s cross-asset short-term trade ideas, the UBS structuring team put together a range of relative value trades that gave investors the chance to go long-short on asymmetric risks, often using the product as an overlay in the alternative bucket of its asset allocation.
“Under this offering the client gets exposure to the ideas generated in an unfunded format via a total return swap which references an underlying portfolio, and actively manages the portfolio,” said Tuninetti. “Once a particular idea is generated the client can decided to include it or not in the swap.”
One popular exposure over recent months was long US financials, short sovereign securities, on the bet that banks will perform better than safe-haven bonds as rates rise.
“That has been a great trade in the US in 2017,” said Tuninetti. “In Europe, we are in fact still long financials, but the trade has not yet crystallised.”