Like rich food and fine wine, in the world of structured products it is possible to have too much of a good thing. The cause of indigestion among dealers today is the autocallable bond. The high-yielding debt and equity hybrid was once a peripheral retail product, but now represents 80% of equity-related structured note issuance in Europe and Asia.
A torrid fourth quarter across global equity markets left Natixis with a €260 million hit on its Korean autocall book. Other major issuers of the products posted double-digit declines in equity trading revenues for the quarter. Now, dealers are hiking their prices on some products, and seeking to adopt a more balanced diet of structures.
“I think there’s a common push for diversification that we didn’t have for the last two or three years,” says Jean-Francois Mastrangelo, head of structured products at Societe Generale.
Autocallable bonds have proven irresistible to investors over the past decade, with their juicy 5%–10% coupons in a low rate environment. Issuers and distributers of the products have been only too happy to satisfy demand. In bull markets, an upside barrier means products can mature in just six months, triggering reinvestment into a new generation of notes and a constant stream of fees.
But the products come with a health warning for buyers and sellers. In bear markets, investors are at risk of losing their principal if products breach the downside barrier. For issuers too, the exposures can quickly become toxic. Sensitivity to complex risks such as correlation, volatility and dividends can whip around wildly in choppy markets. With all issuers positioned the same way on the same indexes, dynamic hedging can create crippling feedback loops as dealers chase up the cost of the very protection they need to accumulate.
For autocall dealers, 2018 has been a sobering year. Big falls across global stock markets hit issuers on two fronts: high hedging costs and reduced reinvestment fees as deals failed to mature, or knock out, in industry speak. Dealers are now left with burgeoning exposure to underlying indexes such as the Euro Stoxx 50, where knockouts have been almost non-existent since mid-2018, dealers say.
“The books keep growing and liquidity in the market is not indefinite, so it’s definitely becoming more challenging for traders to manage their books,” says Renaud Meary, global head of equity derivatives distribution sales at BNP Paribas. “The industry needs to look for alternatives because we cannot just rely on a rally in the market to get rid of the challenges the industry faces today.”
Looking underneath the hood of autocallable bonds, the product consists of two elements: a series of digital options, which pay the investor if the underlying hits certain strike prices, plus a down-and-in put option, which the investor sells to the issuer. The premium generated is rolled into an above-market coupon, which the investor receives at observation dates when spot remains between the two bounds. If spot breaches the upside barrier – typically set at 105–110% – instruments knock out early, paying back principal plus an improved coupon. Investor principal is at risk if spot plumbs the lower barrier – typically set at 50–60%.
As dealers struggle to manage their bloated holdings of autocallables, some have responded by repricing new products linked to the Euro Stoxx 50, which underlies an estimated $120 billion equivalent of autocallables. According to Meary, upfront pricing on new trades is now around 0.6% to 1% higher than six months ago.
“It’s significant and likely to extend further if the market doesn’t rally more. At the current level of markets, the proportion of products able to autocall until the end of the year is not very big so we are likely to see continued conservativism on pricing.”
Others agree that products may become dearer. Since the market has coalesced around a single product, structural innovation has lost out to price as investors chase the biggest coupons on offer.
A lot of actors have realised that you can’t sell an autocall with no margin as if it were a vanilla product. It has to reprice one way or anotherJean-Francois Mastrangelo, Societe Generale
“The big story for 2019 is the repricing that’s taking place. It’s progressive and I’m not sure it has finished yet,” says Mastrangelo. “A lot of actors have realised that you can’t sell an autocall with no margin as if it were a vanilla product. It has to reprice one way or another.”
Some relief may be on its way for issuers of Euro Stoxx 50 related products. One European issuer believes that ES50 autocalls issued in late 2017 and early 2018 may begin to knock out when the index hits 3,500. The index is currently at 3,435.
“The real trigger for the market is 3,500. We would need a bit of time to stay at that level, but that would decrease the whole pressure on the market,” says the equity derivatives head.
Away from Euro Stoxx instruments, pricing pressures have been less evident for the wider autocalls market. Year-end stock market declines mean products failed to knock out, leaving little on the table for reinvestment. An equally sharp rally across global indexes through the first quarter of 2019 quickly shut the door on potentially attractive entry points, forcing investors into wait-and-see mode and curtailing issuance.
“This year has been very good to highlight where autocalls work well and where they don’t,” says Frank Copplestone, chairman and managing partner at Levendi Investment Management. “A lot of clients are sensitive to entry points when they come to buy structured products. Volumes have been light so far this year in part because clients feel markets have rallied too much, too soon and may be holding off until markets retrace to better entry levels.”
Lower demand, combined with a seasonality effect, which sees traders eager to fill their books early in the year, has magnified aggressive pricing on some autocall products, such as multi-index structures and some mono-products linked to Asia-Pacific benchmarks.
“Where you have numerous banks competing for business and having budgets to achieve for the year, you’re going to find such products keenly priced,” Copplestone adds.
Dealers reckon new issue volume is running 30% below first-quarter 2018 levels, with wealth clients in Hong Kong, Singapore, Switzerland and the UK leading the slowdown. Many remain cautious over the global macroeconomic environment and equity performance after six months of whipsawing markets. For example, the UK’s FTSE 100 shed more than 12% over the course of 2018, while the Euro Stoxx 50 shed 15%. Both have sharply rebounded since the start of the year – the FTSE up 10% and the ES50 up 15% as of April 3.
For now, autocalls look set to remain the dominant product, though investors may no longer be able to rely on a bottomless pit of issuance.
“While you have low rates and moderate volatility, autocalls are going to be the default choice,” says Tim Mortimer, managing director at Future Value Consultants, a structured products research firm. “People get used to the idea of target returns, so the strategy of an annual return if the market moves sideways and with a defensive barrier at 50–60% is very attractive.”
Living on the hedge
Previous blow-ups in the autocallables market demonstrate how tricky it is to hedge the product. In 2015, the Street lost a combined $300 million on autocallables when the Hang Seng China Enterprises Index sank 40%. Three years earlier, autocall dealers lost $500 million as the Nikkei 225 zigzagged. At the end of 2018, signs of hedging panic were seen on Kospi, Euro Stoxx 50 and even S&P 500 – a common but typically benign constituent of popular “worst-of” products linked to baskets of indexes (see box: Worst-of structures: S&P 500 causes pain).
The trouble stems from the down-and-in put option leaving dealers with a long volatility position. As spot heads south, increasing the probability of downside barriers being breached, the dealer’s sensitivity to volatility, or vega, increases. This forces exotics desks to sell put options to flatten risk. Such hedging is standard practice for structured products and tends to create an upended spot and volatility dynamic where the two parameters become correlated and fall in tandem. As spot moves closer to the lower barrier, an inflexion point is reached – so-called peak vega. At this point, structured products hedging norms break down, and even the most seasoned exotics traders begin to sweat over potential losses.
Near to the downside barrier, the long vega position associated with the product falls away, leaving dealers short volatility from the puts they sold on the way down. Traders rush to buy back volatility en masse, driving up the cost and creating a feedback loop that can result in heavy losses.
As the Euro Stoxx 50 nosed below 3,000 last December, some analysts noted an early surge of volatility buying as dealers pre-empted the inflexion point – estimated to have been around 2,500–2,900 – and positioned themselves in a bid to avoid sky-high hedging costs typically paid by latecomers.
According to one equity derivatives trader at a US house, no amount of repricing is enough to cover potential hedging losses in turbulent and unpredictable markets.
“To win a trade, you know where you need to price. Our models take into account a range of sensitivities including rates, funding, dividends, vol-of-vol, but if you take into account all the effects in your pricing, you’ll never be competitive enough to win a trade. A pure mathematician would say the price of an autocall is infinite because to hedge all the costs of the autocall you’d have to spend an infinite amount of money,” he says.
Without products knocking out, autocall dealers are now feeling the strain. Many freed up additional capacity to satisfy burgeoning demand through an expansion of alternative risk transfer activities – the slicing and dicing of risk into sources of yield for hedge funds and other sophisticated investors.
The problem is there is often a mismatch between the long-dated exotic risk sitting on banks’ books and short-dated trades that are attractive to hedge fund clients.
“If you’re recycling a risk with a trade that matures after a year, the sensitivity is going to remain in the book,” the trader says. “That’s not pure risk transfer because you have a duration mismatch and after a couple of months, the trade isn’t actually hedging the risk any more.”
Natixis’s Asian losses came a year after the bank expanded its alternative risk transfer activities to include new hedge fund payoffs that aimed to offset correlation and currency risk associated with Korean worst-of autocallables. In February, the dealer was thought to have sold a third of its Korean structured products portfolio to banks including Bank of America and BNP Paribas.
No magic dust
Diversification away from autocalls would benefit banks, but whether investors are yet ready to wean themselves off the product depends on the ability of structurers to create attractive replacements.
“Given what happened last year, the whole industry might be happier if the product base was more diversified,” says Mastrangelo. “Banks have a strong interest to diversify. So far, end-investors haven’t, but they are going to welcome more diversity of products, particularly if they are more stable in terms of coupons.”
One proven source of alternative products – equity-linked participation notes – are almost impossible to structure with the requisite capital guarantees against a backdrop of near-zero rates. The instruments offer investors exposure to an index, basket of indexes or single stocks over a defined period with full or partial downside protection. Structures can be diverse, but typically entail a low or zero-coupon note with equity exposure provided via a call option.
Although participation is typically partial or capped, the benefit over full-blown equity investment is that the instruments typically come with a full capital guarantee at maturity. This is financed by the additional interest the investor forgoes on the note. In high rate environments, structurers can combine a full principal protection with a healthy equity participation rate. In low rate environments, the products lose their appeal as there isn’t enough juice to structure the guarantees.
The problem with participation products is that you need to find an area where you are really bullishFormer structurer at a European house
Though participation payoffs can be complex, hedging is typically more straightforward than for autocalls, which require stochastic volatility modelling to manage the correlation between spot and volatility. Issuers of participation notes are still exposed to parameters such as dividends and repo, but dealers say those risks are more manageable, assisted by the tendency towards diverse underlyings and payoffs.
Popular participation products included “mountain range” options such as Everest, Himalaya and Altiplano, which exploited the correlation between baskets of underlyings to cheapen the option. Low rates scuppered their appeal and according to traders the economics remain wide of the mark.
Levendi’s Copplestone says rates would need to jump by more than 1% across Europe in order to spark interest in participation products. Even then, it may only be possible to offer partial capital protection at 90–95%. For full capital guarantee products to make a comeback, rates may have to rise in excess of 2%.
It isn’t just low rates weighing down the popularity of participation products. Investors require a degree of conviction that an equity market rally has further to run before jumping into such instruments.
“The problem with participation products is that you need to find an area where you are really bullish. I’m not sure whether you want to buy a call strike at 4,000 on the S&P 500 or a 4,000 strike on the Euro Stoxx, regardless of where rates are,” says a former structurer at one European house. “If you want to launch participation products you probably need the market to drop a bit more because it becomes tougher and tougher the higher you go.”
Mortimer from Future Value Consultants is more optimistic on the outlook for alternative structures, including participation products.
“We’ve seen a few other product types remain quite common, such as reverse convertibles, digitals and participation products. We’ve also seen one or two super trackers for accelerated market growth. They used to be very popular after a couple of market falls but have fallen away since,” says Mortimer.
Accelerated growth products offer double or triple the upside for the first portion of a rally and gains are capped thereafter. Reverse convertibles typically provide shorter-dated exposure to single stocks. Current interest in participation products is largely confined to US dollar-denominated structures, where higher rates have enabled principal protection.
BNPP’s Meary sees more investors starting to look at alternative indexes for their autocalls, whether national benchmarks or proprietary indexes created by banks. He also sees rising retail demand for repacks. Issued via certificates, repacks combine government, corporate or subordinated financial debt with a structured payoff to bolster the yield.
The answer, though, may lie in a new, as yet undiscovered blockbuster – a holy-grail product that could match autocall returns without leaving banks exposed to large doses of complex, unhedgeable risk.
“Banks have spent a lot of time and energy working on autocalls for the last decade and maybe they should have spent some of this time on alternatives,” says the former structurer. “All of these houses claim to have the best engineers in the world so it should be their task to find something better.”
Distributors too could soon begin lose patience with autocallables if knockout and reinvestment rates languish. One of the core benefits of autocalls compared to participation products is their ability to knock out as markets rally, creating a constant and reliable stream of fees during bull markets.
“There’s definitely a quest to find a super-appealing product to diversify from autocalls, given the concentration, but at the moment it doesn’t feature in client requests,” says SG’s Mastrangelo. “Retail investors are happy with autocalls.”
Until investor appetite for autocallables shows signs of fading, banks will need to keep the product on their menu, no matter how difficult they are to hedge.
Worst-of structures: S&P 500 causes pain
The S&P 500 index, a common constituent of Korean autocallable bonds, caused a headache for issuers of popular “worst of” structures during the fourth quarter of 2018.
Korea’s structured products market – one of the largest in the world at $60 billion notional equivalent – is dominated by worst-of autocall structures, which reference the worst performer in a basket of indexes. The products use correlation between the underlying benchmarks to cheapen the embedded put option and boost the coupon.
Popular constituents include Hang Seng China Enterprises Index, Nikkei 225, Korea’s Kospi, Euro Stoxx 50 and S&P 500.
In bullish conditions, S&P 500 would normally emerge as an underperformer in the basket, thereby driving valuation of the instruments on the way up. But bull markets are an easy scenario for autocall dealers to manage. On the way down, it’s a different matter.
Normally it is a unpredictable HSCEI that drives performance during turbulence. In December 2018, it was the customarily well-behaved US benchmark wreaking havoc.
“Most of the time it was Euro Stoxx or HSCEI being more volatile, which means that in all these complex scenarios of markets going down, everyone would worry about Euro Stoxx and HSCEI greeks; dividends, correlation between vol and spot and repo,” says an analyst at a European house. “If the S&P suddenly becomes more volatile, you have to worry about all these parameters and change your hedges, which can be relatively long-dated. It’s possible it becomes more expensive as you’re having to hedge multiple indexes now.”
Four analysts told Risk.net that the phenomenon may have contributed to the fourth-quarter pain.
During the final quarter of 2018, the S&P 500 lost 14%, compared to a 9% slump on HSCEI and 12.5% on Euro Stoxx 50. At its peak underperformance – on December 24 – the US equity benchmark was almost 20% down from the start of October. The Vix index of options-implied volatility on the benchmark hit 3 – its highest level since 2011.
Autocall dealers, typically geared up to hedge HSCEI parameters, rushed to hedge volatility, dividends and a range of exotic parameters on the S&P 500.
A strategist at a US house says: “You never previously had a concentration of risks for dividends or repo on the S&P because it was the outperformer, but that happened in December and we saw some unusual selling pressure of midterm volatility and dividends. It makes it more expensive to hedge a worst-of basket as you can’t ignore S&P 500 any more.”
Editing by Alex Krohn
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