UBS’ $1.47 million autocalls on regional banks, energy ETFs show dispersion risk, volatility

By Emma Trincal

New York, Feb. 9 – UBS AG, London Branch’s $1.47 million of trigger autocallable contingent yield notes with memory interest due Aug. 5, 2026 linked to the least performing of the SPDR S&P Regional Banking ETF and the Energy Select Sector SPDR Fund are high on the risk spectrum given the volatilities of each underlier and their low correlation to each other. For Clemens Kownatzki, finance professor at Pepperdine, moreover, the challenge was to determine which of the two was the most likely to be the worst-performer.

The notes will pay a contingent quarterly coupon at the rate of 14.75% per year if each ETF closes at or above its coupon barrier, 70% of its initial level, on any related observation date. Contingent coupon payments will include any previously unpaid coupons, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the coupon if the shares of each ETF close at or above the initial share price on any quarterly call observation date after six months.

If the notes are not called and the final share price of each ETF is greater than or equal to the 70% downside threshold level, the payout at maturity will be par plus all unpaid coupons.

Otherwise, investors will be fully exposed to the decline of the worst performer from its initial share price.

Volatilities

Kownatzki compared the volatility of each ETF.

Given the risks of default in the regional banking industry, the SPDR S&P Regional Banking (“KRE”) displayed a greater volatility than the Energy Select Sector SPDR Fund (“XLE”), he said.

“KRE has been more volatile than XLE for the past three years.

“The big spike was in March when Silicon Valley Bank went under,” he said.

Silicon Valley was the largest U.S. bank closure since the 2008 financial crisis. During the same time, another regional institution, Signature Bank, also collapsed. On a bigger scale, last year’s bank crisis also saw UBS taking over failing giant Credit Suisse.

“At that time, KRE had a volatility of almost 60%. It was high for a sector fund, especially a bank ETF,” he said.

The SPDR S&P Regional Banking ETF has currently 140 holdings.

“Smaller banks were more volatile than energy. It goes against what you normally assume if you don’t look at the data,” he said.

Another factor contributing to the higher volatility of the SPDR S&P Regional Banking ETF was the size of its constituents, generally mid-cap companies, he noted.

“Smaller size companies tend to be more volatile. XLE on the other hand is a mega cap ETF. Companies like Exxon and Chevron are huge,” he said.

Troubled anniversary

Perceptions of risk in the regional banking industry have not receded.

As the first anniversary of last year’s crisis nears, recent shocks have hit the industry again.

On Jan. 31, the stock price of New York Community Bancorp plummeted after the bank reported large losses on its commercial real estate loan portfolio.

“When you buy KRE, you have to be comfortable with the risk carried by commercial real estate assets.

“News stories, market analysts have thrown out some numbers, which estimate defaults from $700 billion to $1 trillion coming from loans that are going to be reset at higher rates,” he said.

As a result, banks could be facing billions of dollars in losses.

Community banks would be especially exposed to this refinancing risk, he noted.

“They’re local lenders, and commercial real estate is a primary source of business for them,” he said.

Another risk factor for regional banks is the economy.

“The pending recession that hasn’t happened yet would be much more harmful to the smaller banks than to the big ones,” he said.

A strange bundle

Kownatzki wondered why invest in the worst of two sectors, which are so different and uncorrelated.

But for those seeking yield enhancement, the notes “delivered” the expected objective.

“A 15% coupon is fairly high for an income note,” he said.

Still, investors needed to assess the risks. One aspect of the necessary due diligence was to look at the correlations.

For a worst-of, the greater the correlation, the lower the risk to investors.

From 2021 to beginning of 2022, the correlation between XLE and KRE was pretty high, close to 70%, he said.

“After that, the correlation turned negative for a few months then positive again. Now it’s barely positive at around 20%,” he noted.

“The correlation between the two is very weak. It certainly explains the high coupon.”

Tenor, barrier

The relatively short duration of the notes was another concern for Kownatzki.

“This two-and-a-half timeframe is tricky. By the time the notes mature we may have a change in Administration. How would it affect oil prices? It’s very hard to tell. I wouldn’t want to hold a note for two-and-a-half years knowing that there’s a 50% chance that we may have significant transfers of power in Washington,” he said.

The 70% barrier within this timeframe may also be “too thin,” he added.

At pricing, the initial price for KRE was $49.70 and $83.41 for XLE, according to the filing. Those levels set the barriers prices at $34.79 and $58.39, respectively.

“The KRE barrier would take us back to 2020 levels. It seems low but in two-and-a-half years, a lot of things can happen,” he said.

The barrier threshold for the energy ETF however was struck even more recently.

“We hit that price two years ago and the note will mature in two-and-a-half years. Again, anything can happen in that timeframe, especially in the energy sector,” he said.

The contrarian view

Despite his emphasis on the risks posed by the banking sector, Kownatzki took the opposite view in his conclusion.

“There is a commercial real estate problem with looming defaults likely to hit banks. But I’m actually more concerned about energy. I see potential for losses in this sector,” he said.

“If I reasoned as a contrarian, I would think that a lot of the downside risk related to regional banks must be priced in already. Everybody knows that many defaults are coming. And how do we quantify the risk? Isn’t $1 trillion an exaggeration? Is it possible that many of us may be overreacting to the New York Community Bancorp reports a few weeks ago?

“There is a lot of room for speculation on both sides of this issue.”

More uncertainty arose from investing in energy, he said.

“What we know for sure is that energy is extremely sensitive to geopolitical risks, we know that geopolitical risks have not been priced in by the market and we also know that we can’t forecast geopolitical events,” he said.

Both ETFs can drop in price, he noted. But the important part of investing in the notes was to predict which of the two was likely to be the lesser performing underlier and if the return was worth the risk.

“Despite all the headlines around regional banks I would be more concerned about energy given the tensions and wars in the Middle East and in the rest of the world,” he said.

The memory was perhaps the only feature Kownatzki found attractive.

But the structure showed too many drawbacks.

“I would have preferred a deeper barrier,” he said.

The timeframe was also a problem.

“I see a greater risk in energy. Making bets on oil ahead of a change in administration is not exactly perfect timing.

“Perhaps this note is really linked to energy, not banks.”

UBS Securities LLC and UBS Investment Bank are the agents.

The notes settled on Feb. 5.

The Cusip number is 90279WL28.

The fee is 0.14436%.

© 2015 Prospect News.
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