Absolute value deals are resurfacing amid directionless market, but some point to drawbacks

By Emma Trincal

New York, Jan. 31 - Issuers have recently brought absolute value notes to market, a re-emergence of a trend, sellsiders said. Investors are seeking investments that pay regardless of the market direction as long as the price moves are contained within a range.

"You gain whether the market rises or falls. But those products may look better than they really are," a structurer said.

"They're definitely very popular because they look good," a New York sellsider said.

Equivalent to straddles in options language, these products give a positive return equal to the absolute value of the underlying final price whether the direction is up or down as long as the decline, if any, does not hit a particular trigger price, which is the barrier strike.

Sideways thinking

"There is a strong demand from the buyside because from a risk profile point of view, especially in this market environment, it makes sense," the sellsider said.

"You're getting some payout on the upside usually up to a cap and also some return on the downside above a barrier level.

"It's for people who think the market is going to stay in a range, and a lot of investors are in that frame of mind right now."

For many financial advisers, those structures offer a clear advantage over most knock-out deals: instead of getting par back when the knock-out event does not occur, investors get the absolute value of the decline.

"You have a fair shot at outperforming the market," a financial adviser said.

"On top of that, they usually throw in there much more generous barriers."

Recent autocallables

UBS Financial Services Inc. and J.P. Morgan Securities LLC were the agents for three recent autocallable offerings using an absolute value payout.

The largest one was JPMorgan Chase & Co.'s $15.7 million of contingent absolute return autocallable optimization securities due Jan. 28, 2013 linked to Citigroup Inc. shares.

The notes are callable at a 19.87% annualized premium if on any quarterly observation date the stock closes at or above its initial share price.

If not, investors will get at maturity par plus the absolute value of the return if the stock falls without breaching a 60% barrier. Otherwise, they will be fully exposed to the share price decline.

JPMorgan issued two similar one-year contingent absolute return autocallables, one tied to Apple Inc. shares for $9.32 million and the other to Freeport-McMoRan Copper & Gold Inc. for $9.73 million.

Twin certificate

Barclays Bank plc's 0% barrier notes due Feb. 3, 2014 linked to S&P 500 index, which was scheduled to price Tuesday, is another example. The barrier will be 58% to 63.5% of the initial level.

Investors will get par plus the absolute value of the index return subject to a 30% cap even if the index finishes negative as long as there is no trigger event. If there is one, they are fully exposed to losses.

The structurer, who said this type of note is called twin certificates for the absolute value return up and down, noted that three factors may contribute in today's market to the pricing of those products: the dividend yield, high volatility and high volatility skew.

The volatility skew is the difference in volatility between options that have the same time to maturity but different strike prices.

"With a down-and-out barrier option as used here for the contingent protection, you sell the volatility of the barrier," this structurer said.

"A higher barrier volatility helps push the barrier further away from the spot price, and therefore it offers more protection."

This structurer said that dividends are used by the issuer to finance the absolute return participation while the high volatility and skew are the market features that allow the pricing of deeper protective barriers.

Looking at the Barclays structure, he said, "Personally, I don't think that the volatility or the skew on the S&P are particularly high, and neither is the dividend yield of 2% attractive.

"It would make much more sense to structure these on the Euro Stoxx 50, where all three factors are relatively attractive," he said, adding that the dividend for this index exceeds 4.5% and volatility remains relatively high, although it is falling fast.

Keep it short

HSBC USA Inc.'s $2.36 million of 0% twin participation notes due July 25, 2013 linked to the S&P 500 is another example of a similar structure. It has a 70% trigger price and a 19.5% cap.

"The key with these products is a short duration," the structurer said. "A rise in volatility is usually bad for the payout depending on how much time is left before maturity.

"My advice: never invest in such products with a maturity of more than two years. In fact, keep it preferably below 18 months.

"Long term, those twin certificates seldom perform, and clients are most often disappointed in them."

This is because as time elapses, volatility may rise, increasing the odds of the underlying breaching the barrier strike. When it happens, investors lose their contingent protection and are no longer able to receive the absolute value bonus, he said.

Beyond equity

Some of those products use other asset classes than equity indexes and stocks.

JPMorgan announced 0% autocallable dual directional notes due Feb. 28, 2013 linked to the first nearby month futures contract for Brent crude oil. They are set to price Feb. 17.

The call premium is expected to be 17% per year. The review will be quarterly. The knock-out event occurs if the contract price falls by more than 35% during the life of the notes.

"It's a good alternative if you want to keep a long position on oil for a year," the sellsider said.

As with the other structures, investors get par plus the absolute value of the negative performance of the underlying contract price if there is no knock-out event.

While those absolute value offerings are back, it remains unclear whether the trend will be lasting, the sellsider said.

"The size of those recent offerings is not huge," he said. "It's probably some private-banking types of deals rather than institutional investor."

Gap risk

He noted that his firm stopped offering those structures a couple of years ago because they are not easy to manage from a trading standpoint.

"Say your price goes down from 40% to 39% in just two days before maturity. Within one point [of] difference, the payout goes from 60 to 139. For a trader, it's really hard to manage. There's a huge barrier risk," he said.

"The management of your delta is going to be very tough, especially with an asset like crude where being down 39% is not really difficult.

"It gets worse with a large deal. Imagine having to pay back 139 in a $100 million size deal. That's $39 [per $100], and that's a lot.

"Some traders are comfortable with this, some are less. It depends on the underlying."

The structurer explained that the hedging challenge incurred by the trader, called slippage, ends up being the investor's problem too.

"It's a drawback for the investor because it gets priced into the structure, which slightly worsens the conditions of the product," he said.

In the secondary market, the gap risk may represent pricing risk, according to the sellsider.

"If you're close to the 60% barrier, it's very hard to price," he said.

"If you're in a symmetrical situation, down 39%, you have a potential upside of about 40% and the same downside potential. It will price around par. Who would find value in that?"

Volatility conundrum

Suzi Hampson, structured products analyst at Future Value Consultants, said that straddle structures may be deceiving if marketed as a way to make a lot of money in down markets.

"It's not necessarily as good as it sounds because you need volatility to accomplish two different things," she said.

"If you pick a volatile underlying, you're more likely to breach the barrier. If you don't, you're not going to make a lot.

"You need the volatility in order to generate the return. But you don't want too much volatility because you don't want to breach the barrier. It's a fine line.

"It's hard to have a view on a straddle product. What do you want? It looks like you're covering your bases."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.