Double-digit year-on-year falls in equity markets, super-high volatility and low interest rates are proving a big challenge for US pension funds struggling with short-funded deficits. But that volatility could be the key to making solid absolute returns using structured notes, say dealers.
Merrill Lynch in particular, fresh from surviving September’s cull of investment banks thanks to its merger with Bank of America, is busy marketing autocallables, a type of equity derivative product that can give high coupon payments if markets perform in certain ways.
"Many pension funds need to achieve a high rate of return, typically around 8.5%, which is difficult to achieve even in a bull market. It’s even more difficult to achieve in today’s market, with heightened volatility and low interest rates," says Mike Herarty, Merrill Lynch’s head of structured equity products. "We’ve been working with pension funds to design transactions that help them meet their investment objectives, and one of the more compelling of these is the autocallable, which takes advantage of current high levels of volatility to give investors the possibility of high returns while in many cases mitigating some downside risk."
Merrill says a typical autocallable transaction would be a five-year note linked to the S&P 500. The issuer notes the performance of the S&P 500 once a year, and if on that date the index is sitting above the level it was at on the day the note was issued the buyer is called out of the transaction, getting its initial investment in return plus a high coupon payment. Under present market conditions that coupon prices at between 12% and 14%, says Merrill Lynch.
If the market has not gone above the level it was at on day one, and also has not fallen below 50% of that level, the investor remains committed to the transaction for at least another year. If the investor gets called out at the end of the second year, they get paid their initial investment plus twice the high coupon rate.
Possible negative
A negative outcome for the investor would be if the index never goes above its initial level throughout the lifetime of the product. If that happens, they get their initial investment back at maturity without making a return on it. And if the index plummets to below 50% of its level on the first day, the investor gets the same return as if it had invested directly in the index itself.
Merrill Lynch is able to price in the possibility of earning such a high coupon partly because, unlike many structured note investments, autocallables come with only partial downside protection rather than full principal protection – which has value – and also because the investor sells the upside part of their return distribution. "The investor is selling a barrier on the downside while capping their potential returns on the upside," says Yonathan Epelbaum, Merrill Lynch’s New York-based managing director in charge of equity solutions for pension plans.
In trading terms the investor is selling optionality – the investor sells a strip of digital options on the upside – and this optionality is worth more the higher levels of equity market volatility go, while low interest rates also give favourable pricing. So by selling volatility via the autocallable, the pension fund can boost potential returns. Last month the Chicago Board Options Exchange’s equity market volatility index, the Vix, shot up to record some of its highest levels by historical standards, putting extra value in any structured product that lets the investor implicitly sell volatility.
But the autocallable is not the only way investors can take advantage of present market conditions. Pension funds and others are reported to be looking at alternative methods of selling options, such as covered call writing, which involves selling call options, usually in the hope that they will not be exercised, on underlying long equity positions. "Our pipeline of new business has never been greater than it is today," says Ron Egalka, Boston-based president and chief executive of Rampart Investment Management, an investment firm that specializes in the technique.