UBS’ phoenix autocallables tied to Gilead Sciences to show various risk-return outcomes

By Emma Trincal

New York, Feb. 24 – When seeking income via an autocallable product, investors need to understand that the investment is likely to have a short life and may not pay to the fullest, said Suzi Hampson, structured products analyst at Future Value Consultants.

She was referring to her firm’s latest stress-testing report on UBS AG, London Branch’s phoenix autocallable notes with memory interest due March 14, 2018 linked to Gilead Sciences, Inc.

“Many possible outcomes can be assessed based on risk and return outcomes and ultimately it’s the investor who needs to decide what’s best for him,” she said.

Each quarter, if Gilead shares close at or above the trigger price, 75.9% of the initial share price, on the observation date for that quarter, the notes will pay a contingent coupon at the rate of 10% per year plus any previously unpaid contingent interest payments, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the contingent interest payment and any previously unpaid contingent interest payments if the stock closes at or above its initial share price on any quarterly observation date.

If the notes are not called, the payout at maturity will be par unless Gilead stock finishes below the trigger price, in which case investors will lose 1% for every 1% that the final share price is below the initial share price.

Investor scorecard

Future Value Consultants rolled out a new analytical system based on stress-testing. One of the tables in the product’s report – the investor scorecard – shows the probabilities for the occurrence of the autocall. The probabilities are calculated for the base case scenario, or risk-neutral assumption. Results include market risk only.

“This table shows the probability of the autocall by call date. It’s on the first call date that the odds of a call are the greatest,” said Hampson.

“Here it is nearly 50%. It seems like a lot. But it’s a pretty standard outcome with most autocalls.”

She was referring to a 49.58% probability of an automatic call at the end of the first quarter listed in the report.

As the product gets longer, the probability drops to 12% on the second call date, or “point two,” and to 5.42% on point three. It then increases again at maturity with a 17.49% probability, according to the scorecard.

This distribution of outcomes is typical with the so-called “Phoenix” autocallables characterized by a coupon barrier situated at a lower level than the call trigger, she explained.

“There is no call at maturity. What we measure is the probability of getting one’s full capital back and this is more likely to happen at the end than upon a call.

“The full capital return occurs if you’re above the 76% barrier. Call one, two and three require to be above 100.”

Product specific tests

Another table named “product specific tests” offers a chance to analyze the same results based on other market scenarios. Those are bull, bear, low volatility and high volatility. Along with the neutral assumption, the five scenarios are consistently used in the majority of the reports’ tables for stress-testing.

The product specific tests table in addition to including the probability of a call at various dates also comprises the probability of barrier breach.

Hampson analyzed those two sets of data in order to offer guidance on how to assess the risk-adjusted return of a product based on a predefined market environment.

“It’s worth taking a look at these call probabilities at various call dates based on what your market assumption is,” she said.

In a bull scenario, the probability of a call at point one increases from 49.58% to 54.47%.

“There is a significant gap between the neutral and bullish scenarios. But it decreases as time elapses,” she said.

Barrier

The same table offers an analysis of market breach by market scenarios.

“These two items – the amount of return you get, which depends on when the call occurs, and the risk of losing money – are the main tools you need in order to decide what the ideal situation is,” she said.

“Needless to say: there is none.”

What is “ideal” will vary from an investor to another.

“You have to be clear about your main goal. “If you want to get the full 10% coupon, you will incur more risk. That’s when measuring the probabilities of a barrier breach is particularly helpful,” she said.

In a bull market, the chances of a breach are the lowest (10.54%) compared to the neutral scenario (15.51%), according to the table.

At the same time, the neutral scenario offers a better outcome regarding the odds of getting paid the full coupon with an 18.19% probability versus 16.46% in the bull market environment.

Bull versus neutral

“Investors who just need the income on a short-term basis without necessarily getting the 10% coupon would be better off in a bull market,” she said.

“If that’s what the investor wants and if they don’t mind the reinvestment risk, that’s obviously the best market scenario for them.

“If, on the other hand, an investor wants to get the full income until the end, a bull environment is not best. It’s the scenario in which they have the greatest chance of being called at the earliest time.

“The neutral assumption in this case is better. But the risk of losing money is higher.”

In general, a constant in most scenarios is the high likelihood of being called on the first observation date.

“Those autocalls are a bit complex when it comes to assessing your risk. Ultimately, your strategy and preferred risk-return is going to be very subjective. Unlike a leveraged note where it’s clear that a bull market is by far your best bet, it’s not that simple with an autocall,” she said.

“The best scenario is for you to decide. It depends on whether your priority is to minimize risk or to maximize your income in dollar terms.”

Breach versus coupon

Hampson compared the respective risks and return outcomes in the neutral scenario versus the bull assumption.

To do that, she simply subtracted the probabilities of barrier breach mentioned earlier for the two scenarios.

She did the same thing with the probabilities of getting the full payment.

She found that the neutral scenario presented 5% more in risk of losing principal but only 1.73% more in the probability of getting paid fully.

“It’s likely that investors for this product would prefer the bullish scenario, which would be the less risky option,” she said.

Middle-ground

A compromise may be found in the less volatile market assumption, according to the table.

In this scenario, there is a 12.44% chance of breaching the barrier, which is greater than in the bull market environment but still lower than in the neutral scenario, she said.

On the other hand, the 21.66% probability of receiving the full coupon provides the best return potential.

Short life

With so many different possible outcomes, a good start for investors is to define their own strategy.

One of the most certain outcomes, which is a constant with autocalls in general, she said, is the high probability of such products to be called at the earliest observation date.

“If you go ahead and buy this product in the hope of making 10% in one year, it’s unlikely to happen,” she noted.

“As long as you know that, then it’s a matter of managing your own expectations.

“If you get called you still have the reinvestment risk. You have to find an equivalent product, and it may not be there.

“What you can expect with this note is to be called in three months almost half of the time. You’d get 2.5% in three months. It’s still attractive. But it’s not the full 10%.”

J.P. Morgan Securities LLC and UBS Investment Bank are the agents.

The notes will settle on March 1.

The Cusip number is 90270KJC4.

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