Principal protection
UNLIKE, SAY, THE manager of a long-only equity fund, who might find it difficult to pull in new customers during a bear market, a structured note seller is in the enviable position of being able to present clients with an upbeat investment case no matter what the market conditions. That’s because it is just as easy to engineer a derivatives-based investment that will increase in value when markets go down as it is to put together a product that will profit when markets are rising. They can even be structured to give an attractive return when markets are moving sideways. It is no surprise then that the credit crisis and subsequent increase in equity market volatility has not fazed structured note issuers. Indeed, they see opportunities, especially for selling to private bank networks, whose clients are relatively quick to take advantage of new opportunities compared with the broader retail market.
The big story, of course, is the increase in equity market volatility. Until the summer of last year, the world’s equity markets were characterized by perennially low volatility. Not so now. At the start of July, implied volatility on the S&P 500 stood around 15. At the start of December it was around the 24 level – which means, on an annualized basis, that the S&P 500 has a one standard deviation probability of being somewhere between approximately 24% above and 24% below its December level.
However, that is nothing compared with the volatility that has swept those banking sector stocks most seriously affected by the sub-prime crisis. Over the same timeframe, the implied volatility on Citi went from around 20 to 44, while Lehman Brothers was up from about 30 to 51, and Barclays from around 24 to 41. This, dealers say, has led to a flood of interest from private bank networks looking to supply their customers with reverse convertibles on banking stock underlyings.
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"Yield enhancement that includes banking stocks probably accounts for something like a quarter of the demand that we are seeing at the moment"
Donald Leitch, Commerzbank |
"In the aftermath of the credit crisis, when equity implied volatilities have shot up, the yield pick-up you get on a structured note such as a reverse convertible is considerably greater. And we have definitely seen a significant pick-up in demand for banking underlyings," says Donald Leitch, head of equity derivatives structuring at Commerzbank in London. "Yield enhancement that includes banking stocks probably accounts for something like a quarter of the demand that we are seeing at the moment."
With a regular convertible bond, the investor effectively buys a call option on a stock. A reverse convertible is structured in a similar way but rather than buy a call option the investor effectively sells a put on the stock or index. The proceeds from the sale of the put are used to boost the yield on the note. Leitch gives the example of a worst-of reverse convertible priced on Citi and Merrill Lynch. A four-month note in dollars with 35% soft protection was yielding roughly 10% in December, he says. A similar note priced in July would have yielded less than half that. A worst-of is a product where the payout is referenced to the worst-performing stock in a basket.
In this example, if over the four-month period either of the stocks has ever fallen to a level of 35% or more below the level it was at when the deal was struck, the investor will get the worst performing of the two stocks delivered – because the put option has been exercised – to them instead of redemption of the note, plus they will get their 10% coupon. If neither of the stocks breaches the 35% level, the investor gets his 10% coupon plus his initial investment back.
Another play
But reverse convertibles are not the only way for wealthy individuals to make a play on the banking sector and get access to yield enhancement. Many dealers also report a lot of demand for auto-callable structures. Auto-callables give the buyer the chance to make a relatively high coupon payment because the investor effectively sells a barrier option. Once a pre-specified condition has been satisfied – for instance that the underlying share price has breached a certain level on certain pre-specified observation days – then the product automatically knocks out, with full repayment of the initial investment.
The structure of the products can take several forms. Jean-Luc Bernardi, London-based head of equity derivatives structuring in Europe for Citigroup, further explains the concept: "In the simplest auto-callables, the market level is observed on each anniversary of the strike date (up to and including the maturity date), and if it is above the initial strike level, then the product terminates on that date and the investor receives their principal back plus a high fixed coupon multiplied by the number of years since the strike date. If the market is not above its initial level on any auto-call date, then the investor receives his principal back at maturity, minus any liability on the knock-in put."
"Many people are looking for a two- or a three-year structure with a semi-annual auto-callable function. If they can get out in six months and have a double-digit coupon, then they’re going to be very happy," says Sarah Rowe, director of UK sales of structured investor products at RBS Global Banking & Markets in London.
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BNP Paribas’ Jean-Eric Pacini is pushing the concept with its Fast Trigger product |
BNP Paribas has taken the concept further with a new product it is currently marketing called Fast Trigger. The idea here is that the payoff is linked to a small basket of stocks, say four banking stocks, and the performance of the underlyings is observed every day. If on any day all four of the underlyings are trading at a level that is 1% or more above its start price, early redemption takes place and the investor gets paid a relatively high coupon payment to close the investment. If early redemption never takes place, the investor gets the worst-performing share at maturity, which could be a few years down the line. Jean-Eric Pacini, head of structured products for equity derivatives at BNP Paribas in London, gives another example: "You might have a basket of three stocks for instance, and as soon as the three have gone up by 1% you redeem early and get a coupon of, say, 12%."