Autocallables are "structured" (read "complex") products that allow the buyer to benefit partially from the performance of an underlying without bearing all the risks.
What elements constitute a self-callable?
- The initial capital, paid by the investor (Mr Smith) to the issuer (a bank).
- Underlying: the asset on which the self-callable payments will be calculated. One of the most commonly used underlyings is the Euro Stoxx 50
- The Coupon: received by the Investor if the Underlying exceeds the 'High Barrier Level'. In recent years the coupons have been between 6% and 12% per annum.
- Maturity date: date until which the product can remain alive. It often occurs in 2 to 8 years at the time of issue.
- Observation dates: dates on which the value of the underlying is measured in order to determine the redemption of the product and/or the coupon payment.
- High Barrier Level: Barrier Level which, if breached by the Underlying on any Observation Date, triggers the redemption by the Issuer of the Denomination and the accrued Coupon Amount. The trigger is automatic and not discretionary, which is why they are callable "auto". Often, it is equal to 100% of the index on the issue date.
- Low Barrier Level: Barrier Level which, if exceeded by the Underlying at Maturity, removes the protection of the Underlying's Denomination. In this case, the Investor bears a loss proportional to the loss of the Underlying. It is often set at 40% of the initial value of the index.
The return for the investor
Now consider that the underlying is a stock market index. We can establish 3 scenarios:
- Scenario 1: the index increases (expanding economy): the investor then receives his initial capital and the coupon. He will have benefited from the rise of the markets within the limit of the coupon.
- Scenario 2: the index falls but does not break the low barrier at maturity (economy in recession). The investor receives the nominal amount but no coupon. The markets have fallen but the investor has not suffered a loss.
- Scenario 3: the index drops and passes the low barrier (economy in deep recession). The investor loses part of his initial capital.
Feed for a self-callable 'Athena' which pays the coupon only at term.
Phoenix' self-adhesive 'Phoenix' with periodical coupon are available.
The return for the investor:
The return for the transmitter
The return to the issuer is, simply, the reverse of the return to the investor.
Typically the issuer (the bank) uses the capital paid by the investor (Mr Jones) to buy the underlying. The issuer thus ends up with a :
Portfolio = (short) self-adjusting + (long) index
Payoff portfolio = Payoff (short) self-callable + Payoff (long) index
The market for autocallables today and the situation for issuers
Globally for the autocallables that are on the market (those issued in 2012 at the earliest), we see a drop in the subjacent that does not exceed -40% (the classic low barrier for autocallables). We then find ourselves in the scenario 2 of those described above.
Evolution of the Euro Stoxx 50
The implications of this scenario 2 are:
- The self-callables that come in The shares will be reimbursed at 100% of the capital at maturity. The sale of the underlying (index) produces an insufficient cash inflow to repay the investor. The banks will recognize a cash outflow and a loss.
- The self-callable ones that are still alive have seen their average life expectancy. The expected date of repayment of a self-callable depends on the expected date on which the index exceeds its starting level. The probability of this event occurring has decreased. If the underlying (the index) exceeds the starting level by the maturity of the autocallable, the investor will receive a cumulative coupon. In the issuer's business plan, the cash from the dividend or capital gain is used to pay this coupon. With longer lifetimes, issuers must hedge the risk related to the uncertainty of receiving dividends for a longer period of time; and. The instruments used to do so are dividend futures or OTC swaps. Recently, trading in dividend futures has been massive:
Trading volume of dividend futures on Euro Stoxx 50
In addition to a bearish trend, the equity market has been a volatile market. Technically, the high and low barriers are respectively a long position on a call and a put. The "Greek letters" of these options have moved quickly with movements in the equity market. Basel III requires banks to hedge risks more actively, and instruments for hedging risks linked to autocallables have seen an increase in demand, with additional costs for issuers.
What about undistributed dividends?
Following Covid, many companies decided not to distribute the dividends they had already announced for 2020. This is a first in history (a "tail event") and issuers of autocallables had not hedged this risk. This fact alone generated a loss of more than €500M for the French banking system.
|Result related to the non-distribution of previously announced dividends
|Earnings from the Equities business in Q1 2020 (change from Q1 2019)
|- 87M€ (-120%)
Against a backdrop of low interest rates, investors in recent years have shown an appetite for self-collaterals, which offered attractive returns. In 2019, self-liquidators accounted for 60% of structured product issues and the market is flooded with them.
French banks are the largest issuers in the world and questions are now being asked about their exposure to this type of instrument. Faced with the same events, the more diversified US banks have managed to show positive results in their equity business.
Some analysts see them as "anti-personnel mines" or the "next bomb" of the financial system.