By Emma Trincal
New York, July 21 – Autocallable notes have exploded this year both in notional and number of sales, and structurers are not surprised as all market conditions are present to push the structure to the forefront, according to interviews with sellsiders and traders.
As they offer above-market interest rates, those products are increasingly popular at a time when the market is not expecting high interest rates any time soon. Structurers have also found creative ways to make those products more appealing in today’s toppish market environment.
Booming
In this year’s first half, issuance volume is up 46% compared to last year but sales of autocallables structures have jumped 164%, according to data compiled by Prospect News.
The data only takes into account equity-linked products in which investors are capped on the upside either by a call premium received upon the call or by a coupon. Autocallable market-linked step ups for instance have not been included as they tend to be uncapped above the digital or step level.
Contingent coupon notes make nearly 90% of the autocalls as defined above, and a large majority of them are based on multi-asset underliers in the form of worst-of payouts.
The number of autocallable offerings has skyrocketed as well, up 145% from last year. It is twice more than the increase in the number of deals overall, up 68%, the data showed.
While the overall volume of structured notes has increased, the market shares of autocallables has managed to increase as well: making for 23% of the total volume last year, these notes now account for 41% of it.
Alpha
Autocallables are used primarily as coupon-enhancers. But a sellsider said that other factors from a pricing standpoint drove volume so far this year.
“Demand is created by the structuring,” he said.
“I personally like these products because they’re allowing you to outperform the market if they’re really well structured.”
As U.S. equity markets keep on reaching new highs, the autocalls are ideal for investors who don’t mind limiting their upside for a certain target return in order to get a higher yield with some limited protection.
“If the market starts to stabilize and become flat, you will outperform,” he said.
“You earn a premium for not knowing how long you’re going to hold the notes. It can be either beneficial or detrimental to you, the investor. But at least you get a premium for the risk.”
Investors in autocallables are always subject to reinvestment risk, a risk they get paid for with a higher premium, which is why autocallables can offer enhanced yield, he explained.
As any prospectus will say, investors reinvesting their proceeds may not get the same rate, or they may have to take more risk to get it.
Risk-return balancing act
But the sellsider said there are ways for structurers to help investors mitigate the risk.
Reinvesting in a lower interest rates environment is the classic concern. But with autocallables tied to equity assets, the possibility of having to reinvest in an uptrend is also problematic, he said.
But the sellsider said there are ways to protect investors from the risk of having to reinvest at a higher entry price.
“What a good structure will try to do is help clients invest the premium at a higher coupon or at a deeper barrier,” he said, adding that it can be done by placing the autocallable threshold below the initial price.
“I always try to put the autocall lower than par. It mitigates the risk. You can reinvest at a lower level,” he said.
Some issuers, for instance Goldman Sachs, have used the strategy. Earlier this month, GS Finance Corp. priced $15.49 million of 2.5-year autocallable buffered notes linked to the iShares MSCI Emerging Markets exchange-traded fund. The call threshold was at 93%, the premium was 7.7% a year and a 20% geared buffer protected some of the downside.
Duration
Another way to mitigate reinvestment risk is to include “no-call periods,” or to extend the maturity, those two techniques being often related to one another.
By extending maturities, structurers can capture more volatility as the pricing model will assume a duration that is longer than the time that elapses between the trade date and the first call date.
Autocallables also facilitate the pricing of downside protection, which low volatility levels have made challenging.
Barriers and buffers are created in selling put options. When volatility is low, the sale of the options does not generate enough premium. Meanwhile, leveraged structures require spending money on call options.
“Autocalls have become a more effective way to add protection. It’s more effective to do it that way than with leverage,” the sellsider said.
“When you try to give participation through leverage, you don’t get much left for the downside protection anymore.
“On the classical autocalls, you just sell options, and all the premium can go into the coupon and the barrier.”
Alternatives are riskier
The search for yield continues to drive demand, remaining one of the central preoccupations for most investors. The question is how much risk should a strategy carry?
Paul Weisbruch, vice-president of options sales and trading at Street One Financial, argued that structured notes on equity may be less risky than some bonds.
“The consensus about higher rates has been abated,” he said.
“The Fed has recently made dovish statement. Inflation is low and the economy is slow.”
As a result, investors do not expect rates to rise dramatically or soon, making the search for yield very relevant, he noted.
“Buying high-yield bonds at these levels is fairly risky. Rallies have already happened; yields are considerably lower than six months ago.
“I can make the case – of course depending on what securities you’re taking about – that you’re taking less risk for more yield in equity compared to certain segments of the bond market,” he said.
Getting yield from autocallables may be one of the most rational approaches, a market participant said.
“People complain that autocallables lose money if the market goes down. So do stocks,” he said.
“At least an autocall gives you a barrier.
Low rates and a toppish bull market are all it takes to drive up sales.
“People want yield. People need a barrier,” he said.
Volume
| First half | 2017 | 2016 | Growth from 2016
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| Total issuance volume | $26.39 billion | $18.10 billion | 46%
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| Autocallable volume | $10.91 billion | $4.14 billion | 164%
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| Percent of total volume | 41% | 23%
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| Number of deals
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| First half | 2017 | 2016 | Growth from 2016
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| Total number of deals | 6,793 | 4,035 | 68%
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| Number of autocalls | 3,791 | 1,548 | 145%
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| Percent of total deals | 56% | 38%
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