UBS’ 7.8%-9.8% airbag autocallables tied to Expedia offer income, but risk is high, analyst says

By Emma Trincal

New York, Sept. 23 – UBS AG, London Branch’s 7.8% to 9.8% airbag autocallable yield notes due Oct. 4, 2017 linked to Expedia, Inc. shares offer investors the benefit of a fixed coupon. But the risk of losing principal at maturity is higher than average, and investors should be familiar with the stock before only chasing the yield, said Tim Vile of Future Value Consultants.

Interest will be payable monthly. The exact interest rate will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if the stock closes at or above its initial share price on any quarterly observation date.

The payout at maturity will be par unless the final share price is less than the conversion price, in which case the payout will be a number of Expedia shares equal to $1,000 divided by the conversion price. The conversion price will be 85% of the initial share price.

Vile in his analysis chose the mid-point coupon rate of 8.8%.

High flyer

“This is quite a volatile stock with price moves that vary with seasonal trends,” he said.

The share price of Expedia is down nearly 12% year to date. The implied volatility of the stock is about 30%.

The price dropped 37% between its 52-week high in November and its low in February.

“Given these roller-coaster moves, you can easily breach the 15% barrier. That’s the main risk,” he said.

“Investors buying these autocallables want the yield. You have the potential to earn 8.8% per year, which is really an equity type of return.

“But chances are you will be called, and if you are, you are more likely to kick out on the first date, three months from now.

“That would give you a 2.2% coupon. Not bad, but you’re taking an awful lot of risk for that.”

Once the autocall is triggered, investors are no longer confronted by the risk of breaching the barrier at maturity.

“However, you still have reinvestment risk,” he said.

Upon early redemption investors may not be able to reinvest the proceeds in a note with a comparable yield, according to the prospectus.

“If you’re looking to get nearly 9% a year, you have to invest again and reinvest, which at the end may end up being challenging.”

Seeking yield

The main advantage of the notes is the fixed coupon, he noted.

“We don’t see that many reverse convertibles with a guaranteed coupon like this one anymore. For investors who need a steady cash-flow stream, this is a fixed-income instrument except that your principal is at risk. It’s a major difference. This note is very different from buying a bond. You get more yield of course, but you are exposed to more risks.”

Typical fixed-income investors would probably avoid this kind of note, he said.

“But this market offers such low rates that many people have no choice but to take on more risk.

“The important thing is to assess the risk.

“If you need that type of income, if you are comfortable with the barrier and volatility levels and if you know the stock ... this may be an option ... but it’s definitely not for everyone.”

Risk

Future Value Consultants provides research reports with scores on risk, return and price comparing each product to its peers, which would be “review reverse convertibles” in this case. Scores are also compared against all products.

The risk is calculated by adding two components, market risk and credit risk. The sum of the two generates the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The notes have a 4.84 market riskmap versus an average of 1.56 for all products.

“It’s extremely high. It’s due to the volatility and the barrier,” he said.

Monetizing volatility

He explained that issuers may have to use volatility when trying to structure fixed interest rates.

“You could have a contingent coupon. It will give you more premium and possibly more protection,” he said.

“Alternatively, you could structure the product around a worst of by adding one or two underliers. As a result low or negative correlations could help boost the coupon as well.

“But if you have only one underlying and if your coupon is fixed, you have to use something else. That’s when volatility comes into play.

“The high market risk is simple enough to explain: the 15% barrier could be easily breached in one year. This is a stock after all that dropped 37% in three months.”

Cushion

The guaranteed coupon of about 9% offers one risk-mitigating feature, however.

“Investors can use it to buffer some of the losses. If the barrier is breached, you’re going to lose at least 15%. But you can deduct the 9% return. You won’t earn any coupon, but you will have a neat little 9% buffer,” he said.

Even with that, investors are guaranteed to lose money once the stock price hits the barrier since the value of the coupon is less than the 15% minimum loss upon the breach, he noted.

“If the stock plummets, you can lose money.”

Riskmap

The credit riskmap of the notes is 0.27, lower than the 0.51 average for all products. It is also less than the average for the same product type at 0.35.

“You have a short maturity, therefore less credit risk exposure in time. Plus UBS has a pretty good credit,” he said.

The credit default swap spreads of UBS are some of the tightest among European banks at 68 basis points, according to Markit. French banks BNP Paribas and Societe Generale have similar spreads of 71 bps and 70 bps, respectively. But Credit Suisse, the other large Swiss bank, shows spreads of 133 bps while Deutsche Banks has global investors fretting with spreads of 231 bps.

Adding the two risk components gives a 5.11 riskmap, compared to the averages of 2.06 for all products and 1.26 for the category.

“It’s not good. You are getting nearly 9%, but the risk is very high,” he said.

Return

The return score measures the risk-adjusted return of a note on a scale of zero to 10 with 10 as the best risk-adjusted return.

The return score is 5.43 versus an average of 6.93 for similar products and 7.08 for all products.

“It’s low. The high riskmap drags the score down. But it’s not only that. You have no participation in the upside unlike other types of notes, for instance leveraged return products. The two factors combined give you a very disappointing result.”

Value

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

To calculate the price score, Future Value Consultants takes into account fees and commissions on an annualized basis. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score for the notes is 4.89 versus an average of 8.24 for the same product type.

“Not brilliant. But the short duration has something to do with that. Since we calculate the fees per annum, you are going to see your value cut short when you pay the fee upfront and have only one year versus three or five to spread the cost,” he said.

“Also we picked the mid-range. If the final coupon is 9.8% instead of 8.8%, a one-point difference, obviously the price score will be much better.”

But fundamentally the barrier level explains the low value of the product as measured by its price score.

“This 15% protection really seems very low for such a volatile stock.”

The issuer could have either increased the protection or the coupon or both, he said.

“They could have spent a bit more on the options. ... It would have helped the score. The return is not bad. It looks like the barrier is really the weak part of the deal.”

Overall

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes have an overall score of 5.16 versus averages of 7.59 for the product type and 7.66 for all products.

“If you’re looking for a fixed coupon, there isn’t much out there. This one has that. In addition, the coupon isn’t bad at all. These are the positive aspects of the product,” he said.

“But investors need to know what they’re investing in. They should be familiar with the underlying stock and understand the risk of losing money.”

UBS Financial Services Inc. and UBS Investment Bank are the agents.

The notes were scheduled to price Friday and will settle on Wednesday.

The Cusip number is 90275Y468.

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