Business

Auto-callables: an option for investment

The Sterling Report

Dave Cameron

Sunday, January 20, 2013    

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Part one of a two-part presentation.

AS interest spreads tighten (reduction in yields) on most investment grade bonds in the market, we have seen clients looking at new and different structures in order to gain more income or increase the returns on their investments. One such option is Autocallables.

Autocallables have quite a number of variations in structure which are typically short term in nature. As the name suggests these notes get automatically redeemed (or autocalled) when the price of an underlying asset breaches a pre-established threshold (known as the call barrier) on a pre-established valuation date (known as the observation date). The investor receives the principal plus a

pre-determined premium (usually paid in the form of a coupon) during the period that the condition is not triggered and the price/market indicator remains within the specified threshold. Autocallable products may be linked to common stocks, basket of stocks, stock market indices, commodities or other asset classes.

How it works

An investor invests in an Autocallable note. This is usually issued in small blocks of a minimum of say USD250,000. The note would have a reference asset or assets, which could be a stock or basket of stocks as suggested earlier. At the time of issue the referenced asset is observed and a strike price or pre-determined level is agreed which would typically be 60 per cent-70 per cent of the current price. On each observation date, once the price closes above the pre-determined level a coupon is paid. If the price of the underlying or referenced asset closes above the price at issue the note is automatically redeemed. However if the price goes below the pre-determined price then no coupon is paid. Some of these notes have a memory feature, whereby if on subsequent observation dates you were out-of-the money (lower than the pre-determined price), the coupons eligible would not be paid but accumulate, and if at maturity the price is above that strike price then all coupons are paid retroactively. Of course with such a feature the yield on the note will be reduced as your risk exposure to the asset is also reduced. An observation date could be quarterly, semi-annually or annually. It is important to note that the market can fluctuate only the prices on observation dates are important and all other occurrences are irrelevant.

Important Factors

There are many factors that will impact the value of the notes, the price of the reference asset on any days is usually the most critical. However the value of the notes can be affected by additional factors including:

a) The anticipated volatility of the reference asset;

b) The time to maturity of the notes;

c) Market Interest rates and yields;

d) The creditworthiness of the issuer;

(e) Anticipated Volatility.

The more volatile markets are at the time of pricing or evaluation is the more risky the investment as the probability of breaching the pre-determined price level increases. This means that during a time of high volatility, at inception one will receive higher coupons and on observation dates the price of the notes will tend to be lower and vice versa.

(b) The time to maturity

As with most bonds as the time to maturity reduces, the price of the note increases.

(c) Interest and yield rates in the market generally

Coupons on these notes have a direct correlation with the level of interest rates in the market. As interest rates increase, so do coupons. Therefore existing notes issued previously will automatically decrease in price and vice-versa when interest rates decline.

(d) The creditworthiness of the issuer, including the actual or anticipated downgrades in the credit ratings of the issuer.

As mentioned earlier these Autocallable notes are generally issued by reputable financial institutions. A similar note issued by two financial institutions rated A+ and BBB- will be priced with different coupons resulting from the credit rating of the institution again reflecting the ability of the institution to make good on the relative payments.

Risk Factors

Capital Guaranteed Notes

On each observation the price of the underlying asset is checked against the pre-determined price to decide if the bond is called automatically, interest paid or interest foregone or interest delayed until the price returns above the pre-determined level. On maturity the same would happen and the principal returned plus any coupons as per above.

Barrier Reverse Convertibles

On the maturity of the notes, the price is below the pre-determined level then the underlying asset gets put to the investor at the pre-determined price. This could result in a loss of principal value of the investment. Therefore investors would want to assess the underlying asset and determine that in the long run if this asset has the potential for long-term appreciation.

The Rationale for the investment

The rationale for such an investment is obviously that you get a higher yield than you would get on a similar credit quality straight bond for the tenor. It is most attractive in volatile environments when the trend of the stock market over the medium to long term is positive.

There are many variations to these kinds of notes and the risks vary so speak to your advisor before deciding which note is right for you.

Dave Cameron is the vice president of Fixed Income and Securities Trading at Sterling Asset Management. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

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