Wells Fargo’s autocalls on Energy Select SPDR offer alternative to direct equity bet on energy

By Emma Trincal

New York, May 11 – Wells Fargo & Co.’s market-linked securities due June 7, 2021 – autocallable with fixed percentage downside linked to the least performing of the Energy Select Sector SPDR exchange-traded fund – offer an alternate way to capture gains from energy stocks for investors who want less risk and expected limited growth in the sector, said Suzi Hampson, head of research at Future Value Consultants.

The notes will be called at par at an annual call premium of 8% to 9% if the fund closes at or above its initial level on any annual call date after one year, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless the fund falls by more than 10%, in which case investors will be exposed to any losses beyond 10%.

Classic structure

“This is quite a straightforward autocall. It pays a premium when you kick out,” said Hampson.

The call premium however is not income since it cannot be paid during the life of the notes, she added.

“It’s more of a product for investors looking for a target return. You accept a fixed amount of return in exchange for having the protection of a 10% buffer.”

The tradeoff will allow investors to use the notes as an alternative to the fund, which tracks the energy sector of the S&P 500 index.

“For investors who understand the autocall concept, this note will provide a little bit more protection than investing in the index directly,” she noted.

“It will call each year if the fund is above its initial price, paying you 8.5% a year.”

Equity substitute

The three-year implied volatility of the ETF is 19.4%, she said.

“It’s not very high compared to 16%-17% for the S&P 500 index.”

One difference with a direct investment in the fund is the variable duration of the notes.

“Investors who buy those products are used to this. They’re also comfortable with the target return. This is not about growth and participation in the upside. Your outlook should be moderately bullish.”

The structure benefits those who rightfully bet on a range bound market.

“As long as the fund doesn’t go down, you will get paid,” she said.

“It’s just a different risk/return profile than investing in the equity fund. You get a limited return but you’re also limiting the amount of losses you may incur and the probabilities of incurring those losses.”

Capital performance

Future Value Consultants produces stress testing reports for its clients.

Each report contains a total of 29 sections or tests, which can be customized in any combination.

One of those tests – the capital performance tests table – shows the probability of each of three outcomes (return exactly capital, return less than capital, return more than capital).

The “return exactly capital” outcome (no losses and no gains) would be extremely rare with a 4% probability, according to the Monte Carlo simulation. That’s because this outcome would require two conditions: the absence of any call and a final price down by less than 10%.

The “return less than capital” situation can certainly happen in more than one-quarter of the time. The result would be an average loss of 24% of capital, according to the table.

“It’s not insignificant, but the buffer still reduces your risk by reducing the amount of losses,” she said.

Among the three outcomes, the best one is also the most probable. Seventy percent of the time investors will get more than capital. The average gain in this case would be 11.4%.

Call points

As with any autocallable structure, the most likely call event will happen on the first observation, or “call point.” This is what another table illustrates.

The chances of an autocallable event on the first call point are 51%, according to the “product specific tests” table.

The probabilities decrease from then to 13% at point two and to 5% at point three. At this stage, which is maturity, the odds of a negative performance are high showing a 31% probability of no call.

“That’s not necessarily the same as losing money. You could see the notes mature and get your money back if the index falls within the buffer area,” she said about this last outcome.

Five market assumptions

Future Value Consultants runs its simulation model using five market assumptions.

The neutral scenario is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Four other market scenarios are used (bull, bear, less volatile, more volatile) based on different growth and implied volatility assumptions. Naturally each scenario produces a different set of probabilities. In the bull scenario for instance, the call at point one happens 64% of the time rather than 51% in the neutral market. Similarly, the bear scenario points to a 37% chance of a call at point one.

Back testing

In addition, Future Value Consultants also features back testing analysis in its reports.

The back testing for the capital performance tests shows the frequency of the outcomes over the last five years and the last 10 years.

This analysis does not show major differences with the simulation, Hampson noted. For instance, the frequency of getting more money than principal is also 70% in the last five years, which is the same as the probability seen in the neutral scenario. However, over the past 10 years, the chances of getting more than capital rise to 77%.

In conclusion, Hampson said the notes could be used by moderately bullish investors as an alternative to a direct equity investment in the ETF.

“This is a classic structured product, which could be used by any investor looking to get exposure to this underlying with a different risk profile.

“The buffer is reducing the risk. The autocall schedule provides a fixed return rather than a participation in the underlying.

“This would appeal to people who don’t think they’re going to lose much on the upside,” she said. “They’re satisfied with the return offered. They’re comfortable cutting their return potential for less risk.”

Wells Fargo Securities LLC is the agent.

The notes will price on May 31.

The Cusip number is 95001B3L6.

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