Combining equity market exposure with bond-like returns
The Sterling Report
AS investors return to the equity markets and the US and UK economies signal a fragile recovery, investors are inclined to look for higher yielding assets which are always accompanied by higher risks. However, investors would be wise to prudently manage the types of risks they assume and should beware of the credit risk associated with their investments. Today we will look at instruments that combine features of debt and equity in order to give investors exposure to the upswing in the equity markets, but also to the safety and security of fixed income instruments.
One such instrument is an "autocallable". Autocallable instruments give the investor a reward if a pre-established condition is met. In most cases, the condition usually stipulates that the price of a particular asset must stay within a specified range for the reward to be dispensed. An important feature of this security is the embedded call option. The instrument is automatically "called" (that is, redeemed) by the issuer if the upper limit of the range is breached. During the time period when the condition is not in breach and the asset price is within the stipulated range, the holder is usually paid some form of return on his principal, which can take the form of a coupon. For example, an autocallable may be designed so that if the price of an Apple stock stays within the range of US$500 to US$700, the noteholder will receive a coupon of eight per cent per annum. However, should the price exceed US$700, the note will be called by the issuer. Similarly, if the price falls below US$500 on the observation date, no coupon is paid for that period.
What makes an autocallable attractive?
The coupon paid on the note and the range of price movement relating to the reference asset that is stipulated are the key features that determine the attractiveness of an autocallable note. Important questions to ask include: What is the price history of the underlying asset? When did it breach the "barriers" as identified in the terms and conditions of your note? (How often? How long ago?) What are the expectations regarding future price movement? Be sure that you are convinced of the rationale for the potential movement (or lack thereof) in the price of the reference asset that is linked to the note. Has a sufficiently compelling argument been presented to you to substantiate the movement that is necessary to generate the coupon payment?
Who issued the autocallable?
As an investor, you should ensure that the issuing company is capable of repaying you and honouring its obligations under the terms and conditions of the security. For example, an autocallable issued by an institution that is rated A by the major credit rating agencies, such as Barclays Bank, versus an institution that is rated at below investment grade. Jamaican investors can access the safety and security of the international capital markets right here at home.
When are autocallables a good buy?
Its important to highlight that the availability of attractive autocallables is unpredictable, due to the fact that they are related to spikes in the volatility of equities market. he attractiveness of autocallables is a function of the prevailing environment and market behaviour. The embedded options in autocallable notes increase in value as volatility in the reference assets increase. Investors should look out for rises in volatility in the US equity market as a potential signal for attractive autocallables.
Benefits to investors
* Short tenors: These notes can be structured with relatively short tenors ranging from one to five years. This minimizes the duration risk associated with the instrument.
* Exposure to reference assets without buying them outright: These notes allow investors to benefit from movements in the price or value of a security without having to purchase the asset outright. In cases where an investor is not comfortable with the prospect of a long-term equity purchase but would still like to take advantage of price movement in the short to medium term, autocallables can facilitate this exposure.
* Hedging: For institutional investors, structured notes can be particularly useful because these conditions can be designed as a hedge for your existing asset portfolio / operations.
Autocallables are a great tool for institutional and individual investors alike for a variety of reasons. Chief among them are higher yields, higher credit quality and shorter tenors.
Marian Ross is Assistant Vice President - Business Development at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm