10/15/2013

Always Read the Fine Print on a Structured Note

by

This week we examine a complex structured product masquerading as a straightforward yield note.  Our representative note and its terms can be found here

The name of the note on the term sheet is:

8% Equity Linked Securities due August 6, 2014

Linked to the Common Stock of Halliburton Company

 

Why are we interested?

Have you ever signed up for a cell phone plan offered at $50 per month but discovered that the bill you received was far higher (e.g., access charges, federal excise tax, universal service charges)?  Apparently, you didn’t read all the fine print…

This note presents a similar situation in many ways.   Traditionally, the title of this note would point to a yield-based product with some sort of downside characteristic. Immediately, I would assume a return of 8%, perhaps contingent on some event and with some element of downside risk. On the surface, this looks like a straightforward product.

Upon further reviewing the term sheet, however, I found the terms to be extremely complex. I have seen my share of confusing term sheets, but this is a whole new level.

At issue is a confusing calculated variable titled “Settlement Amount.” First, it’s a cumbersome calculation.  And secondly, the calculation goes a long way toward eliminating any enhanced return.

Based on the terms of the note, this Settlement Amount generates roughly a 10.3% loss if HAL is flat.  So even including the coupon, the total return is a 2.3% loss (8% yield less 10.3% loss) when HAL is flat.  For the investment to break even, HAL must appreciate by 2.575%.

In fact, the note performs well in scenarios where HAL declines by 16% or more, and underperforms in all other cases.

In short, the real purpose of this product is to provide some exposure to HAL while protecting against a collapse in HAL performance.  The cost of that protection is underperformance in every non-collapse scenario.  Whether or not I believe this is the right vehicle to achieve those goals, I think the name of the product does little to explain it’s true purpose.

 

Now, let’s get into the details:

Terms of the trade

Below is the performance formula verbatim from the term sheet.  Friendly warning: the Settlement Amount calculation is so confusing that I needed to review it several times with pen and paper before confirming I had it right – and I used to construct and price these things for a living!!

Screen Shot 2013-11-01 at 3.20.32 PM

 

Technical Breakdown

Basically, in addition to coupons yielding 8% annually, you receive the following gains or losses at maturity:

  • If HAL has increased more than 14% you receive a 65% participation rate for all returns above 14%
    • For example, if HAL increased 15% you receive a 0.65% return (15% – 14% = 1% * 65% = 0.65%) in addition to coupon payments
  • If HAL has increased between 11.5% and 14% you receive a return of principal
    • For example, if HAL increases 13% you receive your principal plus coupon payments
  • If HAL is positive but has increased less than 11.5% you receive 89.7% participation
    • For example, if HAL is flat you take a 10.3% loss on HAL in addition to coupon payments, for a net loss of 2.3%
  • If HAL has declined more than 23.767% you are protected from further loss. Meaning you can lose as much as 23.767% on principal prior to including coupons, which would result in a total maximum loss of approximately 15.767%
    • For example, if HAL declined 30% the investor incurs a loss of 23.767% in addition to coupon payments

Following is the P&L graph of the total return as compared to HAL at maturity. (Note, the HAL return does not include an annual dividend that is currently yielding approximately 1%; incorporating this dividend would make the underperformance look even worse)

PMC EXC 1309 blog always read P&L

 

Takeaway

My issues with this note are two-fold.  First, the language in the term sheet and the terms themselves are, in my opinion, unnecessarily complex and serve to obscure. Term sheets like this could open up the issuer to litigation risk, create investor confusion, and add to the stigma attached to the industry.

My second concern is with the actual performance of the note. As a general matter, I do not have issue with underperforming on the upside when an important element of the note is some level of downside protection or tail risk.  In fact, if this note had been offered as a tail risk product with upside participation I might have taken more kindly to it!  But the terms of this note are such that it underperforms all the way down to that protection level.

 

 

3 thoughts on “Always Read the Fine Print on a Structured Note

  1. I agree that this note does not represent the industry well. It is so convoluted and confusing in its return profile that it makes one question: “What is the angle they are trying to work here?”

    Would it be possible to mimic, in whole or primarily, this note using an equity position and OTC contracts (similar to how one can mimic a reverse-convert note)? If so, it would be interesting to see how efficient this pre-made note is, with its associated credit risk, versus a Do-It-Yourself strategy involving equity and options.

  2. I have no clue in regards the angle but the strategy can be approximated using listed equity options. Using Jan 2015 listed options in HAL, so approx a 14 month term, you can (1) purchase .9 share of HAL, (2) sell .9 calls up 9%, (3) buy .65 calls up 14% and (4) buy .9 puts down 16%. That would cost $51.83 as compared to buying the stock outright at $56.20 today. The total return profile is better and cheaper best on a precursory calculation though slightly longer duration and calculated at a different time.

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