This is the final article in a two-part series

As investors flock to safety, fixed income asset prices have skyrocketed, particularly those of investment grade sovereigns or corporates. With low yields pervading the bond market, investors are inclined to look to riskier assets and territories for return. However, investors would be wise to prudently manage the types of risks they assume and consistently act to minimize the credit risk associated with their investments. Last week, we instroduced “autocallables” as a means for them to achieve higher rates of return without compromising the creditworthiness of their investment. The definition, variations and risks were discussed. Today we will continue to look at autocallables and look at their benefits in more detail.

As a quick reccap, 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” (i.e. 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 such 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 $500 on the observation date, no coupon is paid for that period.

When are autocallables a good buy?

Its important to highlight that there is usually a narrow window of opportunity for the most attractive of these instruments. The availability of attractive autocallables is unpredictable due to the fact that they are related to spikes in the volatility of equities and equities markets.

The 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. The recent rise in volatility in the U.S. equity market has resulted in a few limited opportunities for investors to capitalize on some very attractive autocallables.

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? Why?) 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?

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. Chief among them are higher yields, higher credit quality and shorter tenors. These beenfits are even more valuable given the currently low interest rate environment.

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at https://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