It is easy for investors to be seduced by the phrase “GUARANTEED Coupons” when designing his or her bespoke product. However, it may not always be the most efficient course of action. Take for example in our EU Banking Giants note as seen below, we have a note that’s guaranteed which pays 6% PA. As an alternative, we have another note that pays 12% P.A for 55% coupon barrier.
*We have assumed the guaranteed note to have a tenure of 6 years with 6% returns even though it is highly improbable and usually much less.
Simplifying these numbers into words, it essentially means that for the non-guaranteed note, you can afford to miss HALF your coupon observations and still break even with a guaranteed note.
Fact 2 (with explanations):
Next, we need to investigate the likelihood of missing half of the coupon payments and what it entails:
Referring to Example 1,
For the note to lose half of its coupon payments, the worst performer has to sink below its coupon barrier for half of its observations (RED REGION).
- Which would mean the worst performer has to reduce its value by almost half.
- In this worst-case scenario, missing 50% of coupons would also mean a high possibility of barrier breach (RED REGION).
- In this case, it could potentially be better to liquidate the note mid-term in the region as denoted by the BLUE CIRCLE than hold on to it and risk losing 51% of your capital or more as seen in example 1. In addition, the 2x higher return should help cover the cost of any potential lost.
If we do the math and liquidate in the BLUE CIRCLE (with some assumptions on pricing): Total coupons = 6 observations paid x 6% per observation = 36%
Possible product price = 50-55%
Total redemption = 36% + 55% or 91% returned out of 100% on a potentially losing investment.
However, if we are looking at the guaranteed option,
Assuming the intention* (refer to Fact 3) for guaranteed should equate to staying for the duration of the note (if not it wouldn’t make sense to have a guaranteed coupon) – Total coupons paid = 12 observations x 3% (per observation) = 36%
Assuming note continues its downtrend and finishes below barrier at 30% worst performer – Total redemption = 36% coupons + 30% Worst Performer = 66%.
Compared with the non-guaranteed, the non-guaranteed option provides a higher total redemption in risky situations by providing +25% to offset potential losses by liquidating 3 years earlier and allowing to move into a recovery product that could provide further increase in gains.
In addition, a higher return per Annum will help to buoy product prices.
For example, as of 23rd November 2016, Live ISIN: CH0259238860 product’s price is 90% while its worst underlying is only 60%.
*By holding a guaranteed note, its only benefits is that you will still earn a coupon even when the note is below the coupon trigger and in this case, treading extremely close to protection barrier.
*If u do not intend to hold a note that’s below the protection barrier / coupon barrier for half its term, then purchasing a guaranteed note is highly inefficient as compared to holding on to alternatively an extremely low coupon barrier.
Investors will be paying a higher premium to collect coupons in risky territory that is also highly unlikely to fall to – (10-30% of 100% initial fixing). These extra gains in pricing could instead be pushed for higher returns or a lower protection barrier to further enhance risk/reward profile (as we shall see in Part 2 of the series.
Lastly, something for you to ponder…
Is it a wiser decision to hold a note that earns you double your returns / allows you to miss half of the coupon payments / indirectly shortening the 6 years term by half; if all coupons till then were paid, allows you to liquidate at a lower loss or…
Is it worth holding on to a guaranteed note that is below the coupon-trigger / protection-barrier just to earn half the coupons yet risk losing more than half your capital?
Tl:Dr / Summary
- Non-guaranteed or Conditional coupons sometimes far outweigh a guaranteed note. (Benefits increases with higher volatility underlying)
- “Guaranteed-like”, extremely low conditional coupons provide as much as 2x Returns compared to a guaranteed note.
- Able to forego as much as half of the coupon observations and still yield the same amount of returns as a guaranteed coupon.
- Possible Liquidation of a conditional coupon at a lower loss compared to a guaranteed coupon (Increases with returns).
On our next article we will compare an alternative strategy, with examples, of improving risk management by making use of these additional gains from a guaranteed option.
Visit www.nebafinancialsolutions.com to see our Structured Products and UCITS Funds http://www.nebafinancialsolutions.com/Risk-Rated-Portfolio-DFM, http://www.nebafinancialsolutions.com/real-asset-fund