Falling prices can be interesting backdrop for investors willing to research listed structured products – especially if they don’t have an aversion to complex structures that can pay off in a declining market.
Sadly, most structured products are designed to make money only if the markets rise. But there is a subclass of products that theoretically produce returns even if share prices fail to rise: defensive autocallables.
Conventional autocallables are usually linked to a stock-market index – in most cases the FTSE 100. If, in a year’s time that index is above its initial level when the product was issued, the product is called, the structure winds up and you get a fixed annual coupon or return, which can be somewhere between 7 and 10 per cent.
If the FTSE 100 is not above its initial level, you move on to the next year, and if the product is called then, you receive the accumulated coupons from all previous years.
If you get to the end of the product’s term – five or six years – without it being called, there are two possible outcomes: if the index is still above a protection barrier (usually between 50 and 70 per cent of the initial level) you get your initial investment back. Or, if markets have fallen so far that the index is below this barrier, your capital is reduced in line with the percentage fall.
A defensive autocallable takes this structure and tweaks it – adding a compelling feature for slowly deflating markets: the initial level that must be breached to trigger your annual coupon is lowered each year, usually by 5 per cent, sometimes more.
So if the FTSE 100 is at 6,000 when the product kicks off, every year the call barrier drops by 5 per cent: to 5,700 at the end of year one, 5,400 at the end of year two, and so on, before finishing at the end of year six at 4,200. In essence, you can have your cake and eat it – you stand a chance of a decent annual return, even if the stock market is falling back slowly.
Clearly, defensive autocallables won’t be any use if markets drop like a lead balloon – in which case only cash, AAA-rated bonds and gold will save you. Even so, for adventurous types with a cautious streak, these products look interesting.
Swiss-based private bank EFG has released a heavily collateralised defensive autocallable with an 8.5 per cent annual coupon and a FTSE level that drops by 5 per cent every year for six years. It also has a downside protection barrier at 60 per cent of the initial index level.
Catley Lakeman, a boutique that specialises in structured investments, adds another twist: combining two indices into one product. Ordinarily,
I’m not a fan of over-complicated multi-index structures but this product, based on the FTSE 100 and the S&P 500, has some attractions. In times of stress, correlation between these indices rises so you are essentially making a bet on the same thing – and being rewarded for the complication, to the tune of an extra 1 or 2 percentage points on the coupon.
Defensive Autocallables
A typical structure would have a six-year term and an 8 per cent coupon with a call barrier that stays at 100 per cent for the first four years but then drops to 85 per cent for the FTSE 100 and 65 per cent for the S&P 500 in year five – with downside protection barriers at 70 per cent and 60 per cent of the indices’ initial levels. Catley Lakeman’s products have the rock solid HSBC as counterparty.
Over in the more mass-market space, both Royal Bank of Scotland (RBS) and Société Générale (SocGen) have been issuing structured products based on the same idea.
SocGen has tested the water with a step-down structure (SG93) that mimics a defensive autocallable and could return 8 per cent a year over six years, with the final year’s call barrier at 3900 for the FTSE 100 in November 2016. It also has a structure (SG52) that mimics the Catley Lakeman idea, tracking the FTSE 100 and the S&P 500 and paying 8.5 per cent a year.
RBS has similar structures. There is a twin index product (RS60) that pays a potential coupon of 10.10 per cent and another slightly more attractive version (RS50) that has a coupon of 9.75 per cent per annum. SocGen and RBS act as counterparties to their own products, which is another risk factor.
So, would I buy a defensive autocallable? Probably… but not yet. I’d wait for a bigger and more sustained surge in volatility. I’m still not too worried about bank risk, and the chance of making 8 or 10 per cent a year is better than anything in the bond market right now.
Original source, Financial Times.
