BNP, Goldman and other issuers toying with S&P 500 Futures index for better pricing

By Emma Trincal

New York, Sept. 20 –Issuers are exploring a relatively new asset class designed to increase upside participation for investors, sources said.

The index being used is the S&P 500 Futures Excess Return index, which offers issuers better pricing options.

At least three banks have either issued notes tied to the equity futures index or are working on the analytics, according to data compiled by Prospect News and sources.

BNP Paribas’ deal

BNP Paribas priced the most recent one on Monday – a five-year note paying 300% the futures index returns up to a 90% cap on the upside and providing contingent protection of 20% on the downside. The notes (Cusip: 05610PCV5), which are distributed by BNP Paribas Securities Corp., will settle on Thursday.

“Equity futures used on notes is rare. Issuers do currency futures and commodities futures,” said a market participant.

“But it’s very interesting on the S&P. The pickup you get structuring a note on S&P futures is pretty compelling.”

Forward prices

This advantage has to do with the way forward prices are determined by interest rates, explained Brady Beals, director, sales and product origination at Luma Financial Technologies.

“The futures price is based on the difference between the risk-free rate and the index dividends,” he said.

“In a zero-interest rate environment, the S&P 500 Futures index will outperform. But when interest rates are higher, it’s the opposite. Higher interest rates create a drag on the futures index performance,” he said.

That’s because the cost of rolling the underlying futures contracts goes up.

“And when you expect less return in your index, you can price more leverage. It’s a little bit similar to decrement indices. Same concept.”

Less is more

Decrement indices are innovative indexes creating a fixed, synthetic dividend by deducting a set percentage from the index performance. Such “decrement” while decreasing the return of the original index is also used to buy the options, which are designed to enhance the note performance.

Investors are supposed to win from this tradeoff.

The impact of interest rates on the futures index return is straightforward, said Tim Mortimer, managing director at Future Value Consultants.

“Futures trade on margin. You’re borrowing money for your futures position,” he said.

“Because you have to borrow money, the carry of your futures is the interest rate.”

He offered a hypothetical example: if interest rates are at 5% and the S&P dividend is at 5%, the futures price will be “roughly unchanged.”

But if interest rates increase, the cost of financing the position will erode the return.

“The margin cost requires the S&P to go up more than interest rates for the S&P Futures index to increase,” he said.

Loss and opportunity

He compared the “drag” of higher interest rates to having exposure to a price index, which is stripped of dividends. Note buyers agree to have exposure to the price return of the index, not its total return, for the benefit of better terms.

“With futures it’s the interest rate that drags your return as opposed to the dividends,” he said.

“If you expect a higher drag on the futures index than on the regular index, you can get a higher participation.”

The comparison with a decrement index or a high-dividend index are both appropriate examples of the ways issuers can buy more options in order to increase participation, he said.

Rate bet, hedge

With interest rates playing such an important role in the pricing, some have argued that the notes could be a way to express a directional view on interest rates.

Mortimer did not think so.

“If interest rates go down, the drag will be less, and it should benefit the noteholder. But what the index does is not the most important. What’s more important is its use for pricing,” he said.

Other questions among market participants arose. One of them was whether issuers were adopting the index for hedging purposes.

Mortimer again was skeptical.

“I don’t think the use of the S&P 500 Futures index is going to affect much the transaction cost of hedging because the index is already liquid,” he said.

Divergence risk

One concern among market participants who have studied the concept was the potential divergence in returns between the S&P 500 Futures Excess Return index and the S&P 500.

“If there is a drag of 5% a year, it’s a 15% drag over three years. There’s got to be some breakeven with the leverage,” said Beals.

Naturally, such risk will decrease in a lower interest rates environment.

“If interest rates back down to 1.5% and your dividend is 1.5%, you remove any drag,” he added.

“You simply need the conviction that rates are coming back down.”

A financial adviser argued that the risk of divergence of returns was alleviated by the 97% correlation between the S&P 500 index and the S&P 500 Futures Excess Return index

Taking the example of BNP note, he said that: “in five years, the futures value is supposed to equal that of the S&P. They have to converge. That’s how futures price.”

However, as seen in some filings, investing in futures contracts is quite a different thing than buying a stock index regardless of correlation levels between the two.

Not sold yet

“I’ve been in conversations about the Goldman Sachs idea, but I don’t think it actually makes sense. The pricing looks good, but the math doesn’t. I asked them recently to poke holes in my argument, but I haven’t heard back from them yet,” a second financial adviser said.

The concept is innovative enough to raise both questions and interest.

“People have been asking for it. The market always tries to do something new,” said a sellsider at a bank.

“We haven’t seen enough of it yet to find out if there is demand for it. We’ll have to wait and see. It’s also a complicated index to sell to retail because futures are so hard to understand.”

Goldman deals

Goldman Sachs has already priced a few offerings on the S&P 500 Futures Excess Return index since last month, according to data compiled by Prospect News. Most of these products are autocallable index-linked notes, which provide participation at maturity if a one-time call is missed earlier on.

The last one was GS Finance Corp.’s $1.19 million of three-year notes paying 1.5x the upside with no cap, which priced on Sept.14. GS Finance had issued another deal for $2.3 million a week before.

On Aug. 23 and Aug. 24, GS Finance priced two other deals on this index for $2.13 million and $6.83 million respectively. The latter provided a one-time autocall and 2.5 times uncapped leverage at maturity over a two-year period in addition to a 20% geared buffer on the downside.

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